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Taking Aim at Sacred Cows

Ty Bernicke prefers to test conventional wisdom before he applies it to client portfolios.

Ilana Polyak, 02/25/2010

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Conventional wisdom is just that, conventional. It might serve as a quick guide to making decisions, but it won't necessarily unearth new insights into a problem. That's how Ty Bernicke of Bernicke & Associates of Eau Claire, Wis., thinks about financial planning.

From the beginning of his career, Bernicke has taken on such topics as the optimal withdrawal rates for early retirement, the soundness of rebalancing, and whether or not to use annuities. And he has made a point of broadcasting these views in industry publications in which his peers have felt free to push back on his unconventional conclusions.

"When I first got into the business, I was very young," says the 34-year-old Bernicke, who joined his father's firm straight out of college in 1996. "I needed to establish my credibility and knowledge base, so I began to publish."

Spending Less in Retirement
Bernicke caused a stir in 2005 with an article in the Journal of Financial Planning challenging the accepted wisdom of the 4% withdrawal rate in retirement. The accepted wisdom has been that a retiree can withdraw 4% a year in the first year of retirement and adjust upward each year thereafter to account for inflation. Following this methodology, the acceptable wisdom says, the retiree has a reasonable chance of not depleting his or her portfolio.

But Bernicke made a case for raising the initial withdrawal because he observed that his clients actually spend less--not more-- as they age. There is an initial spike in consumption when people retire, Bernicke noted, as they travel, dine out, and spend time with far-off family. But that tapers off.

"The conversations I have with my 85-year-old clients are completely different than the conversations I'm having with my 60-year-old clients, who are more apt to drive and travel," Bernicke says.

Bernicke found support in annual data from the Bureau of Labor Statistics showing that spending on food, clothing, entertainment, and housing all decline as people age. "It's not uncommon for someone in their 80s to have a seven-year-old Buick parked in their driveway with 10,000 miles on it," Bernicke says. "That's not true for someone in their 60s who will need to replace a vehicle much more often."

The only area in which spending increases with age is health care. But it does not rise as much as the other categories fall, so the net effect is less overall consumption. For that reason, Bernicke tells his clients that they can start with a higher withdrawal rate in the early years if they commit to spending less as time goes on.

Bernicke did not adjust his view in light of the declining stock market; he says he builds portfolios able to withstand periodic shocks. He uses sizable portions of fixed-income investments and annuities for retiree portfolios.

'Annuities' Is Not a Dirty Word
Although Bernicke & Associates is a father-son team--the firm was started in 1985 by Barry Bernicke--it's hardly run like one. The younger Bernicke maintains his own roster of clients, which he built from scratch. The two men even have their own staffs with separate analysts and support people. "I had to build my own book of business, my dad said," Bernicke says. "If I wasn't able to do that, he said, then I shouldn't be in the business."

The son now has a bigger book than his dad, and Ty has even hired another advisor to work with him. "By forcing me to do it on my own, he made me realize how hard it is to build a business," Bernicke says.

When it comes to investing, Bernicke says that he's learned a thing or two from his dad. Among them is that retirement is no time to load up on risk because the consequences of getting it wrong can be devastating. So, he likes to play it safe by using conservative investments for his retired clients that balance both growth and capital preservation. And, surprisingly, annuities play a large role. In a paper published in 2007 in the Journal of Financial Planning, Bernicke concluded that variable annuities with guaranteed minimum income benefits protect portfolios against market risk better than bonds. He back-tested a portfolio of low-cost mutual funds from 1928 to 2007 using 30-year rolling periods, which correspond to the length of time that a client could spend in retirement. The portfolio carried a mix of large-cap, small-cap, and international stocks and intermediate bonds represented by low-cost index funds. He then compared that with a higher-cost variable annuity portfolio with guarantees.

"A high percentage of the time, there was no question about it, the variable annuities did better," Bernicke says. "With variable annuities, you are basically transferring stock market risk to an insurance company." But that observation was made before the bear market. Amid steep equity losses, insurance firms have become less generous, eliminating some guarantees and raising fees on new contracts. "It became too good of a deal for the consumer," Bernicke says.

Now, for clients with portfolios of less than $1 million, Bernicke uses fixed-income exchange-traded funds, such as Vanguard Total Market Bond BND, for the fixed-income portion of a portfolio. For larger account balances, he prefers individual bonds.

In addition to the bonds, Bernicke uses market-linked certificates of deposit, guaranteed by the Federal Depository Insurance Corp. These products have a defined maturity date of four to six years, similar to other CDs. But the product pays a guaranteed return with the possibility of a higher return (up to a limit) based on the performance of a specific index such as the S&P 500 or the MSCI EAFE. It's a way to insulate a portfolio from market downturns but still participate in some of the upside, similar to a variable annuity. As much as 20% of a client's portfolio could be invested in these instruments.

The core portfolios also contain helpings of other Vanguard ETFs such as Vanguard Growth VUG, Vanguard Value VTV, and Vanguard Small-Cap Growth VBK. For portfolios less than $50,000, he prefers offerings from the American Funds lineup such as Investment Company of America AIVSX and Growth Fund of America AGTHX. "The fixed costs associated with ETFs make sense for larger investors, but for smaller portfolios, those fees are excessive."

Younger clients with a high risk tolerance could have an all-equity portfolio, Bernicke says. But he adjusts those percentages depending on his views of where stocks are headed.

Rebalancing with a Twist
Bernicke also stands out in his approach to rebalancing. The standard practice is to sell winning investments at given time periods and buy those that have declined with the proceeds, a practice that ensures that an investor will always be "buying low and selling high."

Bernicke tested this and published his findings in Futures Magazine in 2003. Bernicke looked at the growth of $10,000 from 1980 to 2001 using both traditional rebalancing methodology and a rebalancing approach that called for allocating the entire portfolio to the one category that performed the best in the previous period (essentially a momentum style). The first portfolio grew to $60,000, but the momentum portfolio totaled $700,000. His conclusion: "Winners tend to stay winners and losers tend to stay losers, and that effect persists for some time." Bernicke uses this methodology today, looking at relative strength when he makes investment decisions.

So, sacred cows in Wisconsin take note: Ty Bernicke doesn't take you at face value, and any standard way of thinking will be met with a healthy dose of skepticism.

Ilana Polyak is a New York-based freelance writer. 

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