Retirement is the summit of the investment mountain, and arguably the key event in the portfolio management lifetime. Investors spend most of their working life saving for retirement before suddenly shifting their financial priorities to focus on wealth preservation and income. This change can be stressful and complex, but a well-considered portfolio management plan can ease the transition.
Our portfolio management team works in concert with our advisors and financial planners to balance the four key needs of clients in retirement:
- Portfolio stability
- Inflation protection
- Income generation
- Asset growth and generational transfer
1. Portfolio Stability Rises in Importance at Retirement
The most pressing concern for the retiring investor is often the need for additional stability. Younger investors with stable employment income can typically tolerate more volatility on a daily or yearly basis than those who are depending on their investment portfolio as the primary source of funds. For this reason, assets are usually reallocated from stocks to bonds as investors age. Price movements in the bond market are typically much smaller than those seen in stocks.
However, this is not the only way to lower portfolio volatility. Within the universe of stocks, stable companies like those in the consumer staples and healthcare sectors tend to move only half as much as riskier stocks in the technology or energy sectors—this can be an important consideration within equity portfolios:
2. Inflation Protection Should Not be Neglected
Inflation protection should be another high priority for retired investors, but it is one that is often overlooked in favor of stability. Cash in the bank offers safety, but the relentless effects of inflation almost guarantee a loss of purchasing power over time. Younger investors have only felt the effects of inflation recently, as the world rebounded from COVID-19. However, inflation averaged almost 4% annually over the last 50 years, and some would argue that easy fiscal and monetary policy in recent years heightens the chances that inflation will remain above the low levels we enjoyed over the last three decades. Thus, investments that are unlikely to keep pace with inflation can be very risky, even if their price stability is attractive.
The unusually bad performance of fixed income investments in 2022 highlighted the risks of bonds in an environment of rising inflation and rising interest rates.
While we believe stocks and bonds should remain the foundation of most portfolios, we think assets that perform well in inflationary environments can be a useful addition. These include income-generating hard assets like real estate and infrastructure, as replacement value for such assets increases with inflation and their rents and other revenues often climb along with other prices. Bonds with adjustable interest rates can also be helpful, as the prices of long-term bonds can move substantially as inflation expectations change. We don’t typically include commodities like gold, which generate no income and can be expensive to buy and hold. Such holdings can be counterproductive for retirees in need of consistent income.
3. Thoughtful Income Supplementation is Necessary
Retirees also need income to replace their regular paychecks. Many types of high-yielding investments are appealing at first glance, but often add unnecessary risk as well—there is a good reason that below-investment grade bonds are referred to as “junk”. Additionally, high-yield bonds can be highly correlated to the stock market, providing little diversification benefit.
In fact, investors often underestimate the role of stocks in producing retirement income. Dividend income is typically tax-efficient, but may come at the cost of total return—mature companies that pay high dividend yields often lack growth opportunities, and are forced to return capital to shareholders rather than reinvest for growth. Tobacco companies are one such example—high dividend yields are offset by a shrinking market of smokers and additional regulatory and litigation risk. In general, however, the high total returns generated by equities mean that investors can potentially generate income from sales of stocks while still enjoying some of the benefits of portfolio growth.
The average investor can also benefit from an increasing menu of fixed income options beyond high-yield bonds. Government bonds, asset-backed securities, structured products, residential and commercial mortgages, and other such categories can now be complemented with niche asset classes like music royalties or litigation finance. These asset classes provide a degree of useful diversification and typically yield more than U.S. treasuries.
4. Asset Growth and Tax Management Prepare Portfolios for Generational Transfer
While some of our clients will want or need to spend down their portfolios during their lifetimes, others wish to leave a legacy for their heirs or for charity. In order to do so, portfolios must grow beyond spending plans and be shielded from unnecessary taxes and expenses.
One extremely valuable tool is direct indexing—breaking up a fund or index into its components. Separately managed accounts that hold individual securities are extremely valuable in creating tax assets. Even in years when the market is up, numerous stocks go down in value and can be sold to generate tax savings.
Asset location is another valuable tool in this process. One simple example of this strategy is placing bonds and other income-generating investments in tax-deferred accounts, where profits are shielded from taxes. Growth stocks and related instruments can be placed in taxable accounts and held indefinitely, deferring tax liabilities on unrealized gains.
Finally, long holding periods and low turnover also help minimize taxes. Before a security with significant capital gains is replaced, we calculate the tax liability that must be overcome in order to make the change worthwhile. In many cases, the cost overwhelms the potential benefit—this is one reason why Warren Buffett’s favorite holding period is “forever”. Low turnover also reduces the complexity of client portfolios and statements.
A Consistent Approach Helps Simplify Portfolios
Many of our clients approach retirement with a variety of holdings accumulated over their investment lifetimes, including employer-sponsored retirement accounts, taxable and tax-free personal accounts, bank balances, and health savings accounts. We analyze and recommend portfolios on a consolidated basis, ensuring that a risk/return profile consistent with client preferences is considered across the board. As mentioned above, we are also able to locate assets in the most appropriate type of account to minimize taxes. Finally, we employ a systematic process of asset allocation and security selection so that clients can understand how each individual holding fits into a diversified portfolio and contributes to their needs as retirees. While we utilize a wide range of securities and solutions within portfolios, our holistic approach to portfolio management helps provide clarity and peace of mind for our clients as they transition into retirement.
