How to Create a Retirement Portfolio Strategy


The first rule of retirement income planning is: never run out of money. The second rule is: Never forget the first rule.

It seems simple enough. Where it gets tricky is negotiating between two equally valid but contradictory concerns: the need for capital security and preservation, and the need for growth to cover inflation throughout the retiree’s lifetime. Few people want to take high risk with their retirement fund. Yet a zero-risk investment portfolio—invested only in safe-income vehicles, like US Treasuries—will steadily erode the value of the nest egg, even with very modest withdrawals.

As counter-intuitive as it may seem, zero-risk portfolios are virtually guaranteed to achieve no reasonable economic goals. On the other hand, an all-stock portfolio has high expected returns, but comes with volatility that is likely to be decimated if drawdowns continue during bear markets. The appropriate strategy balances these two conflicting requirements.

Key points to remember

  • Retirement fund portfolios must balance two conflicting needs: capital preservation for safety and capital growth to hedge against inflation.
  • Modern financial theory advocates emphasizing total return rather than income for retirement-focused portfolios.
  • The total return investment approach relies on well-diversified equity assets for growth and fixed income vehicles as a store of value.
  • When the portfolio needs to make distributions, investors can choose between asset classes to reduce stocks as appropriate.
  • A total return investment strategy will achieve higher returns with less risk than a dividend or income focused strategy.

A balanced portfolio

The goal will be to design a portfolio that balances the demands of a liberal income with sufficient liquidity to withstand falling markets. We can start by dividing the portfolio into two parts with specific objectives for each:

  1. The broadest possible diversification reduces equity share volatility to its lowest practical limit while providing the long-term growth needed to cover inflation and achieve the total return needed to fund withdrawals.
  2. The role of fixed income securities is to provide a store of value to fund distributions and mitigate overall portfolio volatility. The fixed income portfolio is designed to approximate money market volatility rather than attempting to increase yield by increasing duration or decreasing credit quality. Income generation is not a primary objective.

Both parts of the portfolio contribute to the goal of generating a sustainable liberal pullback over long periods of time. Note that we are not specifically investing for income; rather, we invest for total return.

Total return vs income

Your grandparents invested to earn income and filled their portfolios with dividend-paying stocks, preferred stocks, convertible bonds and more generic bonds. The mantra was to live off the income and never touch the principal. They picked individual stocks based on their big, juicy yields. It seems like a reasonable strategy, but all they got was a portfolio with lower returns and higher risk than necessary.

At the time, no one knew better, so we can forgive them. They did their best according to the prevailing wisdom. Plus, dividends and interest were much higher in your grandparents’ days than they are today, and post-retirement life expectancy was shorter. So, while far from perfect, the strategy somehow worked.

Today there is a much better way to think about investing. The thrust of modern financial theory is to shift the focus from individual stock selection to asset allocation and portfolio construction and to focus on total return rather than income. If the portfolio needs to make distributions for any reason, for example to support your lifestyle in retirement, it is possible to choose from among the asset classes to reduce stocks as appropriate.

The Total Return Investing Approach

Total return investing abandons artificial definitions of income and principal, which have led to many accounting and investment dilemmas. It produces much more optimal wallet solutions than the old revenue generation protocol. Distributions are opportunistically funded from any part of the portfolio without regard to book income, dividends, interest or losses; we could characterize the distributions as synthetic dividends.

The total return investment approach is universally accepted by academic literature and institutional best practices. This is required by the Uniform Prudent Investment Act (UPIA),the Employees Retirement Income Security Act (ERISA),common law and regulation.The various laws and regulations have all changed over time to incorporate modern financial theory, including the idea that investing for income is an inappropriate investment strategy.

Yet there are always those who do not understand the word. Far too many individual investors, especially retirees or those who need regular distributions to support their lifestyle, are still stuck in grandfather’s investing strategy. If given the choice between an investment with a 4% dividend and an expected growth of 2% or an expected return of 8% but no dividend, many would opt for the dividend investment, and they could dispute all available evidence. that their portfolio is “safer”. .” This is clearly not so.

Total return Investing in stocks

So how can an investor generate a stream of withdrawals to meet their lifestyle needs from a total return portfolio?

  • Start by selecting a sustainable withdrawal rate. Most observers believe that an annual rate of 4% is sustainable and allows a portfolio to grow over time.
  • Make a high-level asset allocation of 40% to high-quality, short-term bonds and 60% (the rest) to a diversified global equity portfolio of perhaps 10-12 asset classes.
  • Dynamically generate cash for distributions based on the situation.

In a bear market, the 40% allocation to bonds could support distributions for 10 years before any volatile assets (equities) need to be liquidated. In a good period, when equity assets have appreciated, distributions can be made by reducing equities, then using any excess to rebalance towards the 40/60 bond/equity model.

Rebalance the portfolio

Rebalancing within share classes will gradually improve long-term performance by applying the discipline of selling high and buying low as class performance varies.

Rebalancing involves looking at the value of the assets in your portfolio (stocks, bonds, etc.) and selling those that have exceeded the percentage assigned to them when you first structured your portfolio.

Some risk-averse investors may choose not to rebalance stocks and bonds during declining stock markets if they prefer to keep their safe assets intact. While this protects future distributions in the event of a prolonged stock market decline, it comes at the cost of opportunity costs. However, we recognize that sleeping well is a legitimate concern. Investors will need to determine their preferences for rebalancing between safe and risky assets as part of their investment strategy.

The essential

In a world of low interest rates, it’s easy for investors to become obsessed with yield. However, even for retirement-focused portfolios, a total return investing strategy will achieve higher returns with lower risk than an income-focused investing approach. This results in higher payout potential and increased terminal values ​​while reducing the likelihood of the portfolio running out of funds.

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Don F. Davis