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Traditional advice won't help retirees

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By Charles J. Farrell

November 20, 2008 1:04 pm ET

Traditional investment advice won’t help retirees deal with the current market environment.

Advisers need to change their strategies to meet the unique needs of investors who must live off their money.

The most popular traditional advice investors hear today is that they need just to “wait it out.” Unfortunately, because retirees need distributions now, you can’t simply tell them to wait it out.

The second most popular piece of advice is that today’s markets provide a “buying opportunity.” Again, this doesn’t work well for retirees. They are generally fully invested and are not adding new capital. Thus, no matter how low the markets go, retirees generally can’t take advantage of the declines.

This traditional advice stems from our reliance on capital gains as a primary source of investment returns.

While that may be appropriate for investors who are still accumulating wealth, it doesn’t work well for those who need to live off it.

If retired investors are relying on capital gains (either from the stock market or from other theoretically “non-correlated” assets), as a primary source of distributions, they may be out of luck. Not only are stocks down, so are bond values, commodities, real estate and just about everything else.

If the traditional advice doesn’t work, what does?

It helps to go back to the fundamentals and analyze the portfolio objectives for retirees.

Retirees generally have two primary objectives: (1) current income to pay the bills and (2) growing income to help combat the long-term effects of inflation. Since current income is the most pressing need, advisers should focus on ways to produce a reasonably predictable level of cash flow.

While bond values have taken a hit lately, a diversified portfolio of government and high-quality corporate bonds can produce a steady income stream.

For instance, the yield on the Lehman Aggregate Bond Index is currently about 5.0%. If you don’t have many bonds in your retirees’ portfolios, you should think about adding some.

Even though stock values have declined, dividend yields are as high as they have been in about 20 years.

With a diversified stock portfolio, the dividend stream could easily reach 3% today. In fact, the yield on the Dow Jones Industrial Average is currently over 3%. If your stock holdings are light on dividends, you should consider reallocating to more dividend-paying stocks.

By combining both asset classes, you can create a portfolio that yields about 4% from bond interest and stock dividends. That yield can be used as a source of distributions for the client’s basic living expenses.

When the client asks how he will get income for the year since the stock and bond markets are down, you review the income projections for the year, as opposed to the value of the account.

The income is highly predictable, whereas valuations are anybody’s guess. The cash flow produces a level of certainty even in very difficult markets.

If you combine the cash flow from bonds and stocks, you can probably solve the current income need for most clients.

Now that we have answered the current income need, how do we help with the growing income issue?

The potential for growing income generally comes from the stock market. The hard part of course is that we never know when we will get those gains. But there isn’t much we can do about that as advisers.

The best we can do is create a diversified portfolio of stocks and wait for the market values to increase. When they do, the stock market gains can be used as either a source of additional distributions, or a source of funds to purchase additional fixed income assets.

Either way, the distributions are growing.

There is, however, a secondary source of growing distributions that investors often ignore: dividends.

Even if the equity markets don’t appreciate, stock dividends tend to grow year over year.

Since the early 1970s, dividends have grown at about 6% per year.

During recessions we should of course anticipate some declines, but over a 15 or 20 year cycle, the dividends are likely to grow above the rate of inflation. Thus, stocks provide investors with two sources of potential growing distributions: capital gains and dividend increases.

When you combine it all, you have a strategy for current income and growing income. These are the conversations advisers should be having with retirees.

Charles J. Farrell is an investment adviser with Northstar Investment Advisors LLC in Denver. He is a regular contributor to On Retirement, an online column that appears on the InvestmentNews Retirement Center at investmentnews.com/retirementcenter.

For other IN Retirement columns visit InvestmentNews Retirement Center.

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