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 sounds pretty straightforward. Where it gets complicated is to negotiate between two equally valid but contradictory concerns: the need for security and preservation of capital, and the need for growth to cover inflation throughout the retiree’s life. Few people want to take top-flight risk with their retirement funds. Yet a zero risk investment portfolio – invested only in safe income vehicles, like US Treasury bonds – will gradually erode the value of the nest egg, even with very modest withdrawals.

As counterintuitive as it may sound, zero risk portfolios are virtually guaranteed to meet no reasonable economic targets. On the other hand, an equity-only portfolio has high expected returns, but comes with volatility that is likely to be decimated if withdrawals continue during bear markets. The appropriate strategy balances these two conflicting requirements.

Key points to remember

  • Retirement fund portfolios must strike a balance between two competing needs: preservation of capital for safety and growth of capital to protect against inflation.
  • Modern financial theory advocates focusing on total return rather than income for retirement-oriented 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 where appropriate.
  • A total return investment strategy will deliver higher returns with less risk than a dividend or income strategy.

A balanced portfolio

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

  1. The broadest possible diversification reduces the volatility of the equity portion to its lowest practical limit while providing the long-term growth needed to cover inflation, and achieves 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 to mitigate the total volatility of the portfolio. The fixed income portfolio is designed to be close to the volatility of the money market rather than trying to stretch the return by increasing the duration or lowering the credit quality. Income generation is not a primary goal.

Both parts of the portfolio contribute to the objective of generating a sustainable liberal withdrawal over long periods. Note that we do not specifically invest for income; rather, we invest for a total return.

Total return to income

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

Back then, no one knew better, so we can forgive them. They did their best under the ruling wisdom. Also, dividends and interest were much higher back in your grandparents’ time than they are today, and life expectancy after retirement was shorter. So, while far from perfect, the strategy worked in a way.

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

The total return investment approach

Total return investing abandons artificial definitions of income and capital, which have led to many dilemmas in accounting and investing. It produces much more optimal wallet solutions than the old revenue generation protocol. Distributions are opportunistically funded from any part of the portfolio regardless of accounting income, dividends, interest or losses; we could characterize distributions as synthetic dividends.

The total return investment approach is universally accepted by the academic literature and institutional best practices. It is required by the Uniform Law on Prudent Investment (UPIA),the Employees Retirement Income Security Act (ERISA),common law and regulations.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. Far too many individual investors, especially retirees or those who need regular distributions to support their lifestyle, are still stuck in Grandpa’s investment strategy. Given the choice between an investment with a dividend of 4% and expected growth of 2% or an expected return of 8% but no dividend, many would opt for investing in dividends, and they could argue against all the available evidence. that their wallet is “more secure.” This is clearly not so.

Total return Investing in shares

So how could an investor generate a cash flow 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 40% tier-one asset allocation to high-quality short-term bonds and 60% (the balance) to a diversified global equity portfolio of 10-12 asset classes.
  • Generate cash for distributions dynamically depending on the situation.

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

Portfolio rebalancing

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

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

Some risk averse investors may choose not to rebalance between stocks and bonds during bearish stock markets if they prefer to keep their safe assets intact. While this protects future distributions in the event of a prolonged decline in the stock market, 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 bottom line

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 investment strategy will yield higher returns with less risk than an income investing approach. This translates into higher payout potential and increased terminal values ​​while reducing the likelihood that the portfolio will run out of funds.


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Don F. Davis

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