No fear: Keeping retired clients calm

“As an advisor, you can’t begin talking about decumulation soon enough,” Daniel Crosby, behavioural finance expert, financial advisor and president of Atlanta-based Nocturne Capital LLC, told a recent meeting of the Investment Management Consultants Association in Toronto. “There’s a powerful positive psychology to getting a head start, and it’s not too soon to start speaking about it with clients who are 50, 40, 30 or even 20 years old. It can be a key differentiator for your practice – if you start early.”

According to Crosby, investor research has shown that although fear of death is common, twice as many people are more afraid of running out of money before they die. This fear motivates them during the accumulation phase of their lives to make the necessary sacrifices to save. But it kicks into higher gear when it comes time to start depleting the nest egg, when many factors – including rate of return and the client’s lifespan – are unknown.

The challenge for you is designing a portfolio for the drawdown years that provides the income necessary for clients to achieve their desired lifestyle, but which also achieves sufficient growth to keep pace with inflation and ensure that the portfolio is not depleted before death. A sustainable withdrawal rate is a key part of the planning, but the portfolio’s value must be monitored regularly and there must be flexibility to adjust withdrawals if the nest egg is being depleted too quickly.

When it comes to withdrawals, it’s advisable for retirees to be conservative to avoid the risk of running out of money. Although a 4% annual withdrawal rate often is used as a guidepost, the rate that you and a client decide on can shorten or lengthen the length of time the client’s assets will last significantly, and the withdrawal rate may need to be adjusted during a lengthy retirement. The withdrawal calculation will depend upon whether the client wants to draw down the principal or leave it intact to pass on as a legacy to heirs or charity.

Financial plans during decumulation also require strategies for managing volatility so that clients can rein in their emotions and stay committed to the asset mix that will help them meet their goals. Moderating client behaviour is a key aspect of your job, as this has proven to be one of the primary determinants of investor success. Crosby cites research that indicates 6% of clients believe managing emotions is important, while a vast 83% of advisors who have learned from experience with skittish clients said client behaviour is what matters.

David Irwin, certified financial planner and regional director with Investors Group Inc. in Pickering, Ont., says that when clients enter the decumulation phase, they become much more sensitive to market fluctuations.

“It’s a much different mindset, when clients are taking money out versus putting it in, and you can visibly see their reactions,” Irwin says. “Dealing with senior clients requires deeper conversations. They’re relying on their savings, and it’s important to provide reassurance.”

Balancing financial needs and maintaining emotional equilibrium is achieved through an appropriate investment strategy that includes diverse asset classes and products, as well as education, setting realistic expectations and hand-holding.

Reaching an agreement with a client on when the portfolio will be rebalanced is important – whether that’s based on time periods, such as quarterly or annually, or the amount of drift from the original asset allocation as markets rise and fall. Sticking to the financial plan also is key, especially in exciting markets.

“It’s not just a matter of letting this puppy ride,” says Sam Febbraro, executive vice president, advisor services, with Investment Planning Counsel Inc. in Mississauga, Ont. “Regular rebalancing allows the investor to buy low and sell high. It’s the last free lunch, and helps take emotion away from decision-making.”

One of the challenges in building a decumulation portfolio is that the fixed-income investments that once were the bedrock of such portfolios, such as guaranteed investment certificates (GICs) and government bonds, are paying skimpy rates of interest. Many clients are climbing higher up the risk/return ladder to corporate bonds, emerging-markets bonds and preferred shares to improve yield.

Some advisors are forgoing traditional bonds altogether, turning to strategies that emphasize a higher share of equities in the portfolio, along with a “cash bucket” large enough to supply a few years of the client’s income needs and avoid having to cash out during a bear market.

Moshe Milevsky, professor of finance at the Schulich School of Business at York University, suggests that insurance annuities could be a solution for part of the fixed-income component of a portfolio and even could be used to replace bonds or GICs altogether. Annuities can provide a healthier income stream than traditional interest-bearing investments due to tax advantages – and the income will last for the rest of the client’s life, no matter how long that is. Once clients have this security, they often willingly commit a portion of their assets to the more volatile equities investments needed for long-term growth.

On the equities side, stocks are at high valuations in many developed markets, and although stocks traditionally offer superior returns vs other asset classes over the long term, equities markets are characterized by occasional, sometimes severe corrections. In the U.S., the key S&P 500 total return index has roughly quadrupled since the bottom of March 2009 and hasn’t experienced a pullback of more than 20%. Some clients are uneasy about the potential for an imminent downturn, while others are sanguine and have hazy memories of how frightening a crash can be.

Rushing to put a big percentage of your clients’ wealth on the sidelines when markets are overvalued in an attempt miss a downturn could result in those clients missing out on the large gains that often occur in the late stages of bull markets.

Clients also may miss out on the powerful rallies that often follow bear markets and end up with a portfolio that severely underperforms one that uses a buy-and-hold strategy. Keeping an appropriate amount invested and in a position to reap the superior long-term returns of stocks is best.

“The key is proper coaching of clients,” says Darren Coleman, portfolio manager and senior vice president, private client group with Coleman Wealth in Toronto, which operates under the Raymond James Ltd. banner. His clients have 80% of their portfolios invested in equities, on average. “For us, the risk isn’t that you can lose money in stocks; it’s that you can run out of money if you don’t invest in them.”

To smooth the ride, advisors may want to increase the focus on dividend-paying common stocks or preferred shares, or emphasize low-volatility and defensive companies. Or add protective put and call option strategies to portfolios. Some clients are increasing their exposure to alternative strategies, such as hedging or short-selling.

Others are adding a slice of alternative products, such as private debt and equity that are not exposed to the daily movements of public markets and can dampen the effect on both volatility and emotional reactions.

Many alternative strategies are available through mutual funds and ETFs, making them accessible to all types of clients.

“Diversification is powerful,” Crosby says. “At a time when valuations in traditional asset classes are elevated, people may want to consider alternative asset classes, such as commodities or emerging markets.”

STAYING STEADY: INCOME STRATEGIES

When developing decumulation strategies for clients in their retirement years, many financial advisors seek alternatives to traditional portfolios balanced between equities and fixed-income.

In some cases, advisors are forgoing bonds and supporting the desired lifestyle of increasingly long-living and active retired clients through a combination of equities and cash “buckets.” Many advisors also are using more packaged income funds, which hold diversified, non-traditional income assets, including common and preferred shares, global bonds and real estate investment trusts.

–Stocks and cash buckets

For those using the stock and cash bucket approach, the lion’s share of a retirement portfolio is allocated to equities to meet the need for growth and inflation protection in what could be a three-decade or longer retirement. The purpose of cash buckets is to meet foreseeable spending needs for two to five years at a time. As cash buckets are depleted, they’re replenished by selling equities incrementally – either on a regular basis, such as annually, or at opportune times, when valuations are high. By having a liquid pool of assets at all times, retirees can maintain their desired spending level through the inevitable stock market ups and downs, as well as benefit from the long-term growth in the share of the portfolio that’s held in a diversified pool of equities.

Paul Delfino, director, wealth management, and senior wealth advisor at ScotiaMcLeod, a division of Scotia Capital Inc. in Kanata, Ont., spends a lot of time educating his clients about why stocks are necessary to fund a 30-year retirement. However, he also warns clients that they must expect continuing global conflicts, changes in political leadership and various other events that will trigger downturns. He recommends a three-year cash bucket for retirees, viewing it as a “financial bomb shelter” that will shelter clients against market crashes, alleviate their fears and encourage them to stick to the plan. Meanwhile, Delfino’s clients will be able to maintain or increase purchasing power by having a significant amount of assets invested longer-term in stocks to take advantage of growth in the good years. “Volatility is not the risk. The risk is [clients] outliving their money or losing purchasing power,” Delfino says.

A typical client with $1 million at the outset could set aside enough in the cash bucket to provide income of $5,000 a month or $60,000 per year, which adds up to $180,000 for three years or 18% of the original portfolio, Delfino says. If markets rise or are relatively stable, he will sell enough stock to replenish the bucket every year. But, if markets drop, the client has enough cash to last three years before being forced to sell any equities at reduced prices.

Delaying the replenishment of a cash bucket until equities recover can’t be done indefinitely and could result in an income cutback during a prolonged stock slump. For clients with sufficient means, a more conservative approach would be for the bucket to be expanded to hold five years worth of living expenses. The trick to this strategy is in refilling the cash bucket, and this can be done through both rebalancing at regular intervals, such as annually or semi-annually, and adding dividends earned in the equities side of the portfolio. If the equities are designed to produce a dividend income of 2%-3%, that can be factored into the client’s annual income stream, so the size of the cash bucket can be reduced accordingly.

Delfino spends considerable time conducting “lifeboat drills” with his clients. He reviews what might happen to their asset values during a market crash and ensures clients’ expectations are realistic. Delfino’s research found there have been 13 severe market corrections since the Second World War, with an average drop of 33% in the U.S.-based Standard & Poor’s 500 composite index. The average time from peak to trough was 17 months.

“It’s better to go through the lifeboat drill before you leave port than when after you’ve hit ice and are taking on water in the north Atlantic,” Delfino says. “Surprise is the mother of panic. No panic, no sell; no sell, no loss. ”

– Balanced funds, growth and cash

As well as cash buckets, many advisors and their clients rely more on multi-asset income funds or packaged fund-of-fund portfolios that pay out a predetermined rate of annual income, often on a convenient monthly basis.

Typically, these portfolios invest in income-producing assets, which may include dividend-paying common shares, preferred shares, government bonds, corporate bonds or international bonds of various types, including those issued in emerging markets. Fund portfolio managers take care of promised income payments and rebalancing, thus sparing you and your client from making decisions on which securities to sell and when.

Daryl Diamond, president of Diamond Retirement Planning Ltd. in Winnipeg and author of Your Retirement Income Blueprint, typically invests 80% of a retiree’s assets in balanced income funds that deliver a predetermined monthly payout. He also puts 15% of assets in growth-oriented, equities-based mutual funds and 5% in cash. The growth bucket holds a mix of large-cap and high dividend-paying stocks, as well as some small-caps to add extra long-term return potential.

Most of Diamond’s clients have retirement portfolios of $1 million-$2.5 million in assets. If the growth bucket increases in value beyond the original allocation parameters, assets can be sold down and either added to the income-producing pot or used to top up the cash bucket, he says. The cash bucket is used as a “buffer” to supplement income if necessary.

Distributions from the income funds typically are 5% a year, but are not guaranteed, which is why Diamond focuses on a handful of well-managed funds that have a record of reliably paying their distributions and also have achieved growth beyond that.

“To have the cash flow managed by a competent professional manager, in addition to the asset allocation and selection of securities, is very comfortable, ” Diamond says. “Clients do not have to decide which investments to sell or when.”

He teaches clients to view financial assets as akin to real estate properties, from which they can take comfort in spending the rent without having to sell the properties to create an income. And this, he says, has a positive effect on client behaviour.

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