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 semiannually, 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, equitiesbased 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 incomeproducing 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.