Risk-averse investors push advisers to their creative limits

One of the biggest challenges financial advisers face when working with clients in or near retirement is convincing them to embrace an appropriate level of investment risk, which is often where psychology must partner with reality.

When considering the extreme example of a client wanting no part of stock-market risk, most advisers suggest turning back time and saving more money.

But, considering the slim chances of the client having access to a time machine, advisers admit there are some creative ways to protect the portfolios of the most risk-averse clients — assuming those clients are willing to accept the trade-offs.

“There is no free lunch out there, but we have done this for clients in a variety of ways,” said Daryl Deke, chief executive of New Market Wealth Management.

For clients who just can’t stomach the idea of stock market volatility, Mr. Deke said he has helped them construct diversified portfolios of traditional bonds, master limited partnerships, business development companies and real estate investment trusts.

“Think of it as combining credit and duration into a portfolio, and it’s especially valuable inside a retirement account because you can be less concerned about the tax consequences,” he said. “There are still risks, because there’s price volatility, but you can build a portfolio where there will be less risk than you get in the stock market.”

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Unless clients have more money than they could possibly spend in retirement, the biggest risk is usually time. And staying ahead of inflation is difficult when abandoning the growth potential of the equity markets.

Consider, for example, that over the past 10 years through March 5, the S&P 500 Index experienced an average annualized gain of 17.06%.

Meanwhile, over the same period, the Bloomberg Barclays US Aggregate Bond Index had an average annualized return of 3.67%.

That kind of extreme performance disparity is often what gives financial advisers fits when clients insist the stock market is too risky.

“I would suggest the number one way to live on 5% of the investor’s assets, without the risk of outliving those assets, is a variable annuity with a guaranteed income rider,” said Tim Holsworth, president of AHP Financial Services.

“I see no future in a 100% bond portfolio, unless the distribution rate is in the 2% or 3% range,” he added.

Thomas McCarthy, senior financial planner at McCarthy & Cox, said it is virtually impossible for most retirees to finance retirement without some exposure to the equity markets, which is why he often resorts to annuity products that tie up client assets and structured notes that expose investors to issuer risk.

“If someone is really conservative they better have really low lifestyle expectations,” he said.

While advisers typically reduce their clients’ allocation to equities as they enter retirement, removing the growth potential of equities entirely can present challenges.

“You don’t really outlive your money, but you can be forced to change your lifestyle if you don’t have enough money,” said Ashley Folkes, senior vice president at Moors & Cabot.

Mr. Folkes said he often sees clients who have worked with advisers on bank platforms that are so risk averse they are reluctant to stray beyond five-year certificates of deposit.

For some clients, he said the answer is structured products that keep investors exposed to the equity markets but offer downside protection.

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The trade-off for that downside protection is limited upside, which can also hurt long-term performance goals.

Mr. Folkes said his preferred method of dealing with ultra-conservative clients is a simple bucket strategy that divides the portfolio into near-term, mid-term and long-term sub portfolios.

The near-term bucket, he said, might be all cash and cash-equivalent investments that can cover living expenses for up to three years.

The mid-term bucket might have a 3- to 7-year allocation objective, which will include some equity market exposure and is designed to replenish the near-term bucket.

The long-term bucket is where the riskier growth strategies are employed.

The key, according to Mr. Folkes is that the client is only focused on the certainty of what’s in the near-term bucket.

Nate Creviston, wealth management analyst at Capital Advisors, is also a fan of bucket strategies for clients who don’t want to think about stock market volatility.

“There are things that can be done, but you can’t go to 100% bonds because any growth will be eroded by inflation,” he said. “Even with our most risk-averse clients, we still need to have some allocation to stocks. The simple math with today’s yields in the fixed income space would see a retiree’s money have a negative real return if they only invested in bonds.”

Ed Butowsky, managing director at Chapwood Capital Investment Management, said unless the client has an oversized retirement portfolio, it will be difficult to finance 25 years of retirement on a bond portfolio yielding 3%.

“If the client is that scared of the stock market, you have to just go to fixed income and then continue to educate the client,” he said. “You have to have things in your portfolio that grow.”

Put another way, Harold Evensky, chairman of Evensky & Katz/Foldes Financial, said, “Unless you have enough money that you can bury it in your backyard, you need to be invested.”

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“Too often, people confuse certainty and safety,” he added. “It may be safe to sit in bonds but the only thing certain is you won’t have enough money once you adjust for inflation and taxes. The risk of being invested in a diversified portfolio over a long period of time is very small.”