Income-Producing Securities

October 3, 2013

According to Morningstar, the whole idea of income-producing securities is flawed—and I think they are right.  In an article entitled “Option Selling Is Not Income,” author Philip Guziec points out that option income is not mysterious free money.  Option selling can modify the risk-reward tradeoff for a portfolio, but the income is part of the total return, not some extra money that happens to be lying around.

By way of explanation, he shows a chart of an option income portfolio without the reinvestment of the income.  As you can see below, it’s pretty grim.

Source: Morningstar

(click on image to enlarge)

Why is that?  Well, the plummeting line is the one where you spend the income instead of reinvesting it in the portfolio.  So much for an income-producing security that has “free” income.  In this graphic context, it is very clear that the income is just one part of the total return.  (You can read the whole article—the link is above—if you want more information on the specifics of an option income portfolio.)

However, I thought the article was great for another reason.  Mr. Guziec generalizes the case of option income funds to all income securities.  He writes:

In fact, the very concept of an income-producing security is a fallacy. A dollar of return is a dollar of return, whether that return comes from capital gains, coupons, dividends, or option premium.

I put the whole thing in bold because 1) I think it is important, and 2) most investors do not understand this apparently simple point.  This can be generalized to investors who refuse to buy certain stocks because they don’t “have enough yield” or who prefer high-yield bonds to investment-grade bonds simply because they “have more yield.”  In both cases, income is just part of the total return—and may also move you to a different part of the risk-return spectrum.  There is nothing magic about income-producing securities, whether they are MLPs, dividend stocks, bonds, or anything else.  What matters is the total return.

From a mathematical standpoint, shaving 25 basis points off of your portfolio every month to spend is no different than spending a 3% dividend yield.  Once you can wrap your head around this concept, it’s easy to pursue the best opportunities in the market because you aren’t wearing blinders or forcing investments through a certain screen or set of filters.  If your portfolio grows, that 25 basis points keeps getting to be a bigger number and that’s really what matters. 

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Current Income

April 12, 2013

Investors lately are in a frenzy about current income.  With interest rates so low, it’s tough for investors, especially those nearing or already in retirement, to come up with enough current income to live on.  A recent article in Advisor Perspectives had a really interesting take on current income.  The author constructed a chart to show how much money you would have to invest in various asset classes to “buy” $100,000 in income.  Some of these asset classes might also be expected to produce capital gains and losses, but this chart is purely based on their current income generation ability.  You can read the full original article to see exactly which asset classes were used, but the visual evidence is stunning.

Source: Advisor Perspectives/Pioneer Investments (click to enlarge)

There are two things that I think are important to recognize—and it’s hard not to with this chart.

  1. Short-term interest rates are incredibly low, especially for bonds presumed to have low credit risk.  The days of rolling CDs or clipping a few bond coupons as an adequate supplement to Social Security are gone.
  2. In absolute terms, all of these amounts are relatively high.  I can remember customers turning up their noses at 10% investment-grade tax-exempt bonds—they felt rates were sure to go higher—but it only takes a $1 million nest egg to generate a $100,000 income at that yield.  Now, it would take more than $1.6 million, even if you were willing to pile 100% into junk bonds.  (And we all know that more money has been lost reaching for yield than at the point of a gun.)  A more realistic guess for the typical volatility tolerance of an average 60/40 balanced fund investor is probably something closer to $4.2 million.  Even stocks aren’t super cheap, although they seem to be a bargain relative to short-term bonds.

That’s daunting math for the typical near-retiree.  Getting anywhere close to that would require compounding significant savings for a long, long time—not to mention remarkable investment savvy.  The typical advisor has only a handful of accounts that large, suggesting that much work remains to be done educating clients about savings, investment, and the reality of low current yields.

The pressure for current income might also entail some re-thinking of the entire investment process.  Investors may need to focus more on total return, and realize that some capital gains can be spent as readily as dividends and interest.  Relative strength may prove to be a useful discipline in the search for returns, wherever they may be found.

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Retirement Stress

March 20, 2013

AdvisorOne ran an interesting article recently, reporting the results of a retirement study done by Franklin Templeton.  Investors are feeling a lot of stress about retirement, even early on.  And given how things are going for many of them, feeling retirement stress is probably the appropriate response!  In no particular order, here are some of the findings:

A new survey from Franklin Templeton finds that nearly three-quarters (73%) of Americans report thinking about retirement saving and investing to be a source of stress and anxiety.

In contrast to those making financial sacrifices to save, three in 10 American adults have not started saving for retirement. The survey notes it’s not just young adults who are lacking in savings; 68% of those aged 45 to 54 and half of those aged 55 to 64 have $100,000 or less in retirement savings.

…two-thirds (67%) of pre-retirees indicated they were willing to make financial sacrifices now in order to live better in retirement.

“The findings reveal that the pressures of saving for retirement are felt much earlier than you might expect. Some people begin feeling the weight of affording retirement as early as 30 years before they reach that phase of their life,” Michael Doshier, vice president of retirement marketing for Franklin Templeton Investments, said in a statement. “Very telling, those who have never worked with a financial advisor are more than three times as likely to indicate a significant degree of stress and anxiety about their retirement savings as those who currently work with an advisor.”

As advisors, we need to keep in mind that our clients are often very anxious over money issues or feel a lot of retirement stress.  We often labor over the math in the retirement income plan and neglect to think about how the client is feeling about things—especially new clients or prospects.  (Of course, they do feel much better when the math works!)

The silver lining, to me, was that most pre-retirees were willing to work to improve their retirement readiness—and that those already working with an advisor felt much less retirement stress.  I don’t know if clients of advisors are better off for simply working with an advisor (other studies suggest they are), but perhaps even having a roadmap would relieve a great deal of stress.  As in most things, the unknown makes us anxious.  Working with a qualified advisor might make things seem much more manageable.

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Seven (Obvious) Steps to a Sound Retirement

December 11, 2012

When I first read this retirement article by Robert Powell at Marketwatch, I thought the advice was useful, but obvious.  Subsequent experience has led me to believe that while it may be obvious to a financial professional, it’s not always obvious to clients.  Clients, it seems, have pretty fuzzy thinking about retirement.

Here’s a retirement step that to me is obvious—but a lot of clients haven’t done it, or haven’t thought about it in a very complex way.  From Mr. Powell’s article:

1. Quantify assets and net worth

The first order of business is taking a tally of all that you own — your financial and non-financial assets, including your home and a self-owned business, and all that you owe. Your home, given that it might be your largest asset, could play an especially important part in your retirement, according to Abkemeier.

And at minimum, you should evaluate the many ways you can create income from your home, such as selling and renting; selling and moving in with family; taking out a home-equity loan; renting out a room or rooms; taking a reverse mortgage; and paying off your mortgage.

Another point that sometimes gets lost in the fray is that assets have to be converted into income and income streams need to be converted into assets. “When we think of assets and income, we need to remember that assets can be converted to a monthly income and that retirement savings are important as a generator of monthly income or spending power,” according to SOA’s report. “Likewise, income streams like pensions have a value comparable to an asset.”

One reason retirement planning is so difficult, according to SOA, is that many people are not able to readily think about assets and income with equivalent values and how to make a translation between the two. Assets often seem like a lot of money, particularly when people forget that they will be using them to meet regular expenses.

Consider, for instance, the notion that $100,000 in retirement savings might translate into just $4,000 per year in retirement income.

I put in bold a section that I think is particularly important.  With some effort, clients can usually get a handle on what their expenses are.  If they have pension income or Social Security benefits, it’s pretty easy to match income and expenses.  But if they have a lump sum in their 401k, it’s very difficult for them to understand what that asset means in terms of income.

After all, if they are just looking for an additional $3,000 per month in supplemental income, their $400,000 401k balance looks very large in comparison.  They figure that it will last at least ten years even if they just draw the funds out of a money market, so 20 years or more should be no problem with some growth.  At least I can only assume that’s what the thought process must be like.

Sustainable income is an entirely different matter, as clients almost never factor inflation into the thought process—and they are usually horrified by the thought of slowly liquidating their hard-earned assets.  No, they want their principal to remain intact.  They are often shocked when they are informed that, under current conditions, some practitioners consider a 4% or 5% income stream an aggressive assumption.

And, of course, all of this assumes that they have tallied up their retirement assets and net worth in the first place.  Lots of retirement “planning,” it turns out, works on the “I have a pretty good 401k, so I think I’ll be all right” principle.  I have a couple of thoughts about this whole problem.  What is now obvious to me is that clients need a lot of help understanding what a lump sum means in terms of sustainable income.  I’m sure that different advisors work with different assumptions, but they are still often not the assumptions your client is making.

Some practical steps for advisors occur to me.

  1. Encourage clients to track their assets and net worth, maybe quarterly, either on paper or on a spreadsheet.  At least they will know where they stand.  A surprising number of clients nowadays are carrying significant debt into retirement—and they don’t consider how that affects their net worth.
  2. Talk to them about what you consider reasonable assumptions for sustainable income.  Maybe you’re still using the good old 4% rule, or perhaps you’ve moved on to more sophisticated methods.  Whatever they are, start the conversation long before retirement so the client has a chance to build sufficient savings.

Sound retirement isn’t obvious, and planning for it isn’t simple or easy.

Note:  The rest of the article is equally worthwhile.

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Retirement Income Failure Rates

September 13, 2012

Retirement income is the new buzzword.  New sales initiatives are being planned by seemingly every fund company on the planet, and there’s no end in sight.  Every week sees the launch of some new income product.  There are two, probably inter-related, reasons for this.  One is the buyers right now are generally leery of equities.  That will probably be temporary.  If the stock market gets going again, risk appetites could change in a hurry.  The second reason is that the front-end of the post-WWII baby boom is hitting retirement age.  The desire for retirement income in that demographic cohort probably won’t be temporary.  The trailing edge of the baby boom will likely keep demand for retirement income high until at least 2030.

Much retirement income planning is done with the trusty 4% withdrawal rule.  Often, however, investors don’t understand how many assumptions go into the idea that a portfolio can support a 4% withdrawal rate.  The AdvisorOne article Retirement in a Yield-Free World makes some of those assumptions more explicit.  The 4% rule is based on historical bond yields and historical equity returns—but when you look at the current situation, the yield is no longer there.  In fact, many bonds currently have negative real yields.  Stock market yields are also fairly low by historical standards, leading to lower expected future returns.  Here’s what the author, professor Michael Finke, had to say:

Estimating withdrawal rate strategies without real yield is a gruesome task. So I asked my good friend, occasional co-author and withdrawal rate guru Wade Pfau, associate professor at the National Graduate Institute for Policy Studies, to calculate how zero real returns would impact traditional safe withdrawal rates.

When real rates of return on bonds are reduced to zero, Pfau estimates that the failure rate of a 4% withdrawal strategy increases the 30-year failure rate to 15%, or just over one out of every seven retirees. This near tripling of retirement default risk is disturbing, but it is not technically accurate because we also assume historical real equity returns.

If we use a more accurate set of equity returns with a market-correct risk-free rate of return, the results are even more alarming. The failure rate of a 4% strategy with zero bond yield and a zero risk-free rate on equities is 34% over a 30-year time horizon. If real bond rates of return do not increase during a new retiree’s lifetime, they will have a greater than one in three chance of running out of money in 30 years.

The bottom line is that low expected returns may not support a 4% withdrawal rate as easily as occurred in the past.  (There may be a couple of more efficient ways to withdraw retirement income than the 4% rule, but the basic problem will remain.)

The practical implication of lower expected returns for future retirees is that they will have to save more and invest better to reach their goals.  Retirement income will not be so easy to come by, and behavioral errors by investors will have a greater impact than ever before.

We may not like what Bill Gross calls the “new normal,” but we’ve got to deal with it.  What can clients and advisors do proactively to ensure the best shot at a good retirement income stream?

  • encourage savings.  Maybe boost that 401k contribution a few percentage points and hector the client for regular investment contributions.
  • diversify by asset class, investment strategy, and volatility.  Don’t put all your eggs in one basket.  It may become important to pursue returns wherever they are, not just in stocks and bonds.  Diversifying your equity return factors may not be a bad idea.  We love relative strength, but value and low volatility mix well.  And it’s probably not a good idea to put all of your assets into cash or highly volatile categories.
  • get help.  There’s a wealth of evidence that good advisors can make a big difference in client outcomes.  A steady advisor may also reduce the chance of bad investor behavior, which can be one of the biggest barriers to good long-term returns.

Investing, even in good times, is not an easy endeavor.  With low or non-existent real yields, it may be even tougher for a while.

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Five Ways to Draw Retirement Income

July 20, 2012

Figuring out how to turn your portfolio into retirement income is a tricky thing because there are two unknowns: 1) you don’t know how the investments will perform, and 2) you don’t know how long you need to draw income.  A recent article from the Wall Street Journal discussed how to optimally tap a nest egg.  It references a study by Morningstar (a link to the Morningstar paper is included in the WSJ article) that compares five different methods.

The authors also propose a metric to determine how “efficient” the retirement income distribution method is.  Some of the methods are fairly heavy on math and count on the investor to use a mortality table and to determine portfolio failure rates using Monte Carlo simulation.  Others, like the 4% rule, are pretty basic.

The math-heavy methods work well, but in practice it might be a little more difficult to get a client to specify if they would prefer the calculation be made for a 50% chance of outliving their money or a 10% chance of outliving their money!  In my experience, clients are much more interested in methods that offer a 0% chance of outliving their money. Actuarial methods are somewhat dependent on the Monte Carlo simulation having a return distribution similar to what has been experienced in the past.  These methods might struggle in the case of a paradigm shift.

As far as simple methods go, the RMD (1/life expectancy or distribution horizon) method and the endowment method are both preferable to the 4% rule.  The RMD (required minimum distribution) method is easy to calculate and simple to adapt to whatever time horizon you choose.  The endowment method (taking a constant % of the portfolio) has the advantage of being relatively efficient over a wide range of asset allocations—not to mention that it has been tested in practice for decades.  Of course, both of these methods take into account the changes in the portfolio’s value, so your distribution may not rise every year.  In practice, endowments often smooth the portfolio value to reduce the income volatility.

The traditional 4% rule (withdraw 4% of the portfolio each year and adjust for inflation) is the worst of the rules tested.  It’s pretty easy for capital to be depleted if a difficult market occurs early in the retirement period because the withdrawals keep accelerating as the market value declines.

The robust methods (RMD and endowment) significantly reduce your chances of ever running out of money, but you have less certainty about year-to-year income as a result.  It’s what I would opt for, but every client’s situation is different.

With thousands of baby boomers hitting age 65 every day now, the Morningstar study deserves a close reading and a lot of thought.


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