Account Information

  • My Account

    Manage all your subscriptions, update your address, email preferences and change your password.

  • Help Center

    Get answers to common service questions, ask the analyst or contact our customer service department.

  • My Stock Talk Profile

    Update your stock talk name and/or picture.



Close

Retirement Investing Part 4: Product Allocation and Sequence of Returns Risk

By Jim Fink on October 19, 2010

Print Friendly

[For my previous articles on retirement investing, see Part 1, Part 2, and Part 3. The following discussion borrows heavily from Investing Daily’s special report on asset allocation strategies].

Gold can perform well during inflationary as well as deflationary periods and is a perfect hedge for long-only portfolios.

Yiannis Mostrous, Global ETF Profits

Understand Product Allocation and Sequence of Returns Risk

Life is full of potential pitfalls and building your retirement nest egg is not immune. Even if you do everything right: (1) accurately calculate your retirement spending need, (2) save enough now to generate a large enough nest egg, and (3) allocate your investments to the appropriate type of account to minimize taxes, you still could end up short of your goal. The reasons? Inflation, living a long time, and sequence of return risk. Poorly-timed market declines, which are out of your control, can wreak havoc on the size of your retirement nest egg. You need insurance products — including stock options — to protect your retirement from danger.

Bottom line: once you have retired and are withdrawing money each year from your retirement nest egg, asset allocation is not enough. You need to supplement asset allocation with product allocation.

Moshe Milevsky, Finance Professor at Toronto’s York University, discusses product allocation in his book Are You a Stock or Bond?, as well as in this interview:

As people transition from accumulating wealth to distributing income and creating an income stream, they are going to have to think more broadly about their investments. Although their asset allocation will not have to change, their product allocation will have to change.

What do I mean by product allocation? Investing in things like annuities, investing in things that have lifetime income, investing in things with downside protection, investing in things that keep up with inflation – product allocation as opposed to asset allocation.

Product #1: Retirement Savings

Retirement savings are but one retirement product, albeit the one everyone is familiar with. Milevsky calls it the “Systematic Withdrawal Plan” and it is the product that benefits from asset allocation. He recommends 70% stocks and 30% bonds for a 65-year-old because it offers the highest likelihood of maintaining a sustainable income stream that doesn’t run out. Milevsky, however, considers only generic stocks and bonds as the possible investment universe.

Financial consultant Geoff Considine, in contrast, says that a more conservative 50% stock, 50% bond allocation is optimal for a 65 year old if you diversify into more asset classes:

Asset Class

Proposed Allocation

ETF Examples

Large-Cap Domestic Stocks

15%

iShares S&P 500 (NYSE: IVV)

Small-Cap Domestic Stocks

5%

iShares Russell 2000 (NYSE: IWM)

Real Estate Investment Trusts (REITs)

5%

Vanguard REIT Index (NYSE: VNQ)

Foreign Developed-Market Stock

5%

Vanguard Europe Pacific (NYSE: VEA)

Utility Stocks

5%

iShares S&P Global Utilities (NYSE: JXI)

Emerging Market Stock

5%

Vanguard Emerging Markets (NYSE: VWO)

Taxable Bond

10%

iShares Barclays Aggregate Bond (NYSE: AGG)

U.S. Treasury Inflation-Protected Securities (TIPS)

40%

iShares Barclays TIPS Bond (NYSE: TIP)

Commodities

10%

iPath Dow Jones-AIG Commodity (NYSE: DJP)

Note: These ETFs are just examples, not recommendations. Based on the quotation cited at the beginning of this article, Yiannis Mostrous of Global ETF Profits would recommend adding a Gold ETF to your retirement portfolio as a hedge against inflation and financial armageddon. For the absolute best ETFs to buy in all asset classes, check out Yiannis’ and Ben Shepherd’s Global ETF Profits investment service.

How Much Can You Safely Withdraw From Savings Each Year?

After retirement, you aren’t earning any money, so you must live off of your retirement savings. As far as an optimal annual withdrawal rate, Milevsky says that an initial withdrawal rate of 4.7% (indexed for inflation at 3% per year) is sustainable, but that a higher withdrawal could be preferable if the person has a higher risk tolerance or other income streams. Financial planner Jonathan Guyton believes that a 6.2% annual withdrawal rate is sustainable if a retiree is willing to follow three rules:

  1. If your portfolio loses money during the year, you can’t give yourself a raise the following year. In other words, if you add up your portfolio’s year-end value and the money withdrawn during the prior 12 months and this sum is less than your portfolio’s beginning-of-year value, you can’t increase your next year’s withdrawal to compensate for inflation.
  1. No matter how high inflation gets, your maximum annual increase is 6%.
  1. You have to avoid selling hard-hit stock funds. Instead, each year, start by lightening up on winning stock funds.

Having a stock portfolio (i.e., Milevsky’s Systematic Withdrawal Plan) is the retirement product needed to protect against inflation risk and erosion of purchasing power.

Two Retirement Risks That Asset Allocation Can’t Solve

Besides inflation, there are two other types of risk in retirement that a stock portfolio does not protect against: (1) longevity risk; and (2) sequence of returns risk. Other retirement products are needed to combat these risks.

Product #2: Lifetime Income Annuity

Who thought that living a long life could be a financial risk? According to the U.S. Department of Health and Human Services, a 65-year-old man has a 39% of living past the age of 85 and a 65-year-old woman has a 30% chance of living past the age of 90!

For longevity risk (i.e., the risk of outliving your assets), an insurance product known as an immediate lifetime annuity does the trick. With an annuity, you are guaranteed a fixed annual payout for life, regardless of how long you live. The advantage of an annuity is that you never run out of money; the disadvantage is that you lose ownership of the up-front payment you make to the insurance company, so that if you die early your heirs are screwed. There is an insurance rider you can purchase that guarantees a minimum payout equal to your initial investment, which is useful for your heirs if you die early, but this rider is expensive and can substantially reduce your annual payout while you are living.

An Ibbotson Associates study found that investing 50% of your retirement savings at age 65 into a lifetime annuity and investing the remaining 50% in a 60% stock, 40% bond portfolio increases the odds that you will not run out of money by age 100 to 58%. In contrast, investing 100% of your savings in the 60/40 portfolio at age 65 provides you with only a 42% chance of still having money at age 100. 

Insurance companies are willing to offer lifetime annuities and assume the risk that you live a long time because they pool longevity risk among thousands of people, many of whom won’t live a long time. The lump sum payments made by people who die early are called “mortality credits” and they defray the cost of paying annuities to people who live a long time.

Product #3: Stock Options, GICs, and PPNs 

The Sequence of Returns Matters in Retirement

Sequence of returns risk is the last risk that a retiree needs to protect against. It comes into play in retirement because of the annual withdrawals made from savings. Without withdrawals, the sequence of returns doesn’t matter. Whether your five-year portfolio returns on $100,000 are -12%, +10%, -8%, +9, and +16%, or the reverse: +16%, +9%, -8%, +10%, and -12%, doesn’t matter. Both sequences provide a total compound return of 12.6% or $112,602 over five years. But things change dramatically when you are withdrawing money every year. For illustrative purposes, I will use a ridiculously high 20% annual withdrawal rate and only a five-year period:

Scenario #1

Annual Return

Withdrawal at Beginning of Year

Year-End Balance

Year 1

16%

$20,000

$92,800

Year 2

9%

$20,000

$79,352

Year 3

-8%

$20,000

$54,604

Year 4

10%

$20,000

$38,064

Year 5

-12%

$20,000

$15,897

 

Scenario #2

Annual Return

Withdrawal at Beginning of Year

Year-End Balance

Year 1

-12%

$20,000

$70,400

Year 2

10%

$20,000

$55,440

Year 3

-8%

$20,000

$32,605

Year 4

9%

$20,000

$13,739

Year 5

16%

$20,000

$0

Getting negative returns to start retirement can have a devastating impact on your retirement and how long you can live without running out of money. Consequently, Milevsky recommends investing in stock options and insurance products that provide downside protection during the five years before and after retirement when sequence of return risk is highest.

Product examples are put options on stock indices and structured products like stock index-linked guaranteed investment contracts (GICs) and principal protected notes (PPNs). For more information on how to use stock options to hedge your portfolio, check out Investing Daily’s new special report, Options Trading Strategies and Your Complete Options Trading System.

===============================================================================

Exchange-traded funds (ETFs) are the perfect tools for constructing a well-diversified global portfolio. Editors Ben Shepherd and Yiannis Mostrous of Global ETF Profits recommend the best asset classes to invest in now. Try this market-beating newsletter risk-free today!

Stock Talk — Post a comment Comment Guidelines

Our Stock Talk section is reserved for productive dialogue pertaining to the content and portfolio recommendations of this service. We reserve the right to remove any comments we feel do not benefit other readers. If you have a general investment comment not related to this article, please post to our Stock Talk page. If you have a personal question about your subscription or need technical help, please contact our customer service team. And if you have any success stories to share with our analysts, they’re always happy to hear them. Note that we may use your kind words in our promotional materials. Thank you.

You must be logged in to post to Stock Talk OR create an account.

Create a new Investing Daily account

  • Use Social Connect
  • - OR -

* Investing Daily will use any information you provide in a manner consistent with our Privacy Policy. Your email address is used for account verification and will remain private.