The “floor/leverage” strategy

This strategy, referred to as “floor/leverage”(F/L), calls for segregating a client’s money in two accounts: one filled with safe investments; the other, with much riskier instruments.

In the so-called “floor” account, a client would invest the bulk (85%) of his or her retirement money in low-risk, income-generating assets, such as ladders of zero-coupon bonds or annuities, suggest the paper’s co-authors, Jason Scott, managing director of Sunnyvale, Calif.-based Financial Engines Retiree Research Center, and Stanford University professor John Watson.

In the “leverage” account, the client would invest the balance (15%) of the money in high-risk investments, such as exchange-traded funds or mutual funds that maintain an exposure leveraged three times to equities daily. The result, the authors say, is an effective limited-liability spending and investment strategy.

Because the target equities allocations are maintained automatically, a retired client can use all the available floor account’s dollars to purchase income. In retirement, spending money is withdrawn only from the floor portfolio.

If the equities portion of the leverage account exceeds 15% of the overall portfolio, then the client would sell enough equities to return to the 15% allocation and use the proceeds to ratchet up spending while supported by the secure floor portfolio.

This way, while spending can increase, it doesn’t ever need to decrease. Although the leveraged equities allocation potentially could be eradicated during a bear market, the secure spending floor remains in place and the client is exposed to, at worst, a 15% drop in the worth of their overall assets.

The authors compared their F/L method with some popular retirement strategies, such as the 4% rule and the “bucket” approach. They found the F/L option to be both easier to implement and maintain – all assets can be purchased and held between annual spending reviews – and more effective.

The 4% rule counts on future market returns to sustain spending, and if that doesn’t materialize, reacts by cutting spending or risking ruin. In contrast, the F/L option never needs to reduce spending if equities returns are poor. In fact, F/L reacts to reduced returns by reducing risk -the leveraged portfolio rapidly declines, the authors note, resulting in a lower total portfolio risk.

The authors also looked at whether clients would be able to maintain a reasonable withdrawal rate – about 3%-5% of initial wealth – over the course of their retirement by using an F/L approach. What was determined, using historical equities returns, was that spending is always sustained despite traumatic market events – although the leveraged account’s value varied sharply, depending on equities returns.

One caveat, of course, is that in today’s low interest rate environment, the amount of safe and sustainable spending that most retirees can count on by locking up 85% of their assets might prove to be too low for their needs.

In addition, the emotional impact of potentially losing the entire leveraged portfolio may prove too great for many older clients.

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