Fri, 22 Jun 2012
Premium Member Video: Financial experts John Ameriks, Sue Stevens, and Bill Bernstein address how to allocate fixed-income assets, the importance of total return, the role of annuities, retirement distribution rates, and more in this special panel discussion hosted by Christine Benz.
Christine Benz: I am Christine Benz for Morningstar. I'm director of personal finance. And this panel is called tackling the retirement-income challenge. The challenge, of course, is that it's very difficult to wring a real income stream from a portfolio these days without taking a lot of risk on. So I am happy to say that we have a very able panel here to offer varying perspectives on this important set of issues.
John Ameriks is here from Vanguard. He is on my far right here on the stage. John leads the firm's investment counseling and research group. He is also a principal at the firm, and he is on the investment committee for several of the firm's funds, including the managed payout funds. I wanted to put in a little plug for some of the research that Vanguard does in terms of planning and retirement. I know it's been a treasure trove of information for me personally, and if you haven't gone on Vanguard's site to check it out, I would urge you to do so. That is the output from John and his group.
Sue Stevens is also here from Stevens Wealth Management in Deerfield, Ill. Sue is a longtime friend and contributor to Morningstar. She has earned many, many honors over the years for her work as a planner, and she also has a very long array of designations after her name. She is a CPA, a CFA, a CFP and an MBA, and we're very happy to have Sue here.
Finally Bill Bernstein is here all the way from Oregon. Bill is an asset-allocation theoretician, and I've learnt a lot from Bill and have his books on my bookshelf which include the Birth of Plenty, The Investor's Manifesto, and The Four Pillars of Investing. He is also a neurologist. So we have a lot of overachievers up here today.
The thing I want to kick off with is something that keys in on Jeremy Grantham's presentation, and I know that many of you saw it. Jeremy described bonds as disgusting. And we are all here to talk about what retiree portfolios should look like, and we all think of bonds as mainstays in retiree portfolios. So, I'd like to hear from this panel about what role fixed income should play in portfolios for retirees. Is the standard asset-allocation advice about tipping more and more of the portfolio into fixed income still worthwhile? Bill, let's start with you because you do spend lot of time focusing on asset allocation, specifically.
Bill Bernstein: Well, the purpose of bonds in your portfolio is as a safe asset. They are what let you sleep at night. They are to be there when you want to buy cheap stocks. They are there to pay your living expenses. They are there for emergencies. They're there to buy that corner lot that your impecunious neighbor owns who is now in financial trouble because of the crisis; you've always had your eye on that lot.
They're not there for yield. The famous phrase goes that 'there has been money lost chasing yield than has ever been lost at the point of a gun.' And I think that we're going to find that's going to be true in the next several years. The main thing is safety. At the end of the day, there are risky assets, and there are riskless assets. And whatever you do, don't confuse the two.
Benz: Bill, so just to follow-up on that, your prescription for fixed-income allocation for most retirees would be to keep it fairly safe and keep it short, correct?
Bernstein: That's right, yes. You know, a long bond, even if it's a Treasury, is not a safe bond. It's been that way for the past 30 years, but I don't think it's going to be that way going forward.
Benz: Sue, how about for you and your practice in terms of allocating client assets? Is your take similar to Bill's that you sort of use [bonds] as ballast for the equity portfolio, or where do you come out on that?
Sue Stevens: Well, I think I'm similar to Bill in thinking of bonds as being the portion of your portfolio that is sort of the safety mechanism in there, though everything has caveats, so nothing is really safe, and especially right now. But maybe just to build on some points that Bill made, I think one of the things you want to be thinking about is just the depth of diversification in the bond side of your portfolio. And I know probably for a lot of you out there who are advisors, you're hearing from your clients that they just don't understand bonds at all. There's a real disconnect there.
So, helping them understand the difference between a corporate bond and a government bond or the role of high yield in a portfolio I think can add value. It may not be as straightforward as just buying one intermediate index right now if you're trying to help them diversify, not for yield only--I think that would be the smallest reason you do it--but more so from a safety perspective. If you listened to some of the panelists [at the Morningstar Investment Conference] the last few days taking about the role of Treasuries going forward, I think you have to really think about that if that's 50% of your index.
And maybe another thing to add to that is just we hear a lot about investing your age bonds, and I think there is variations on that. I think that's a good place to start. But I think as I look at my clients, and I think about lots of different objectives for them, there might be reasons why you would deviate from that. It might be that you have a legacy issue that you want to make sure that you're funding.
I think you want to think carefully about how much you want in fixed income versus equities, and then I think you want to think about the nature of your equities. If you do have a chance to get more [income] in the way of dividend-paying types of stocks, then maybe you just look at it in totality when you're trying to help your clients.
Benz: So, Sue, from a practical standpoint, when you think about client portfolios and their allocations, would you say you have ratcheted down fixed income a little bit versus where maybe you were 10 years ago?
Stevens: No, I'd say it's close to the opposite, and that's because of what happened in 2008. I think we have always been conservative; we have always been fairly balanced. But since 2008 I'd say a lot of clients want that sleep-at-night factor, and they are probably a little more in bonds than we were 10-years ago, plus they are 10-years older. So it's moving in that direction, and that's why it's so tricky as an advisor to figure out what do you make up that bond portion with and what do you make up the stock portion with.
Benz: Well, let's talk briefly about that what is the complexion of your fixed-income component in client portfolios right now?
Stevens: I'm definitely ratcheting down Treasuries. I think, there is still a role for Treasury Inflation-Protected Securities although that's going to be the same issue, if there is a funding issue out there with paying for health care going forward and government debt gets downgraded again, at some point that will take a toll I think. So, I'm looking at the role of high yield. I look at all those charts with the boxes that show you where high yield goes every year, and we all kind of experienced what happened in 2008. But I think there is a role in proportion for what you want in high yield. I think corporate bonds are much bigger than I have ever done in the past, so I'm looking at what kind of corporate bonds I want, where I want to be if I want to be in funds. For some of us advisors we also are always weighing [whether to point clients to] individual bonds [versus] bond funds, and that kind of depends on what you are working with.
Benz: The client asset level?
Stevens: Yes. So that's kind of what I'm thinking about.
Benz: John, I want to follow-up with you. Sue mentioned the role of Treasuries, and we all know that Treasuries and government bonds have a very big role in the Barclays Capital Aggregate Index, which is kind of linchpin of Vanguard's bond lineup. What's your take on that question when you hear from clients who say, "I'm not sure I want to have two thirds of my fixed-income exposure in U.S. government-related bonds?"
John Ameriks: You and I talked a little bit before we sat down. I think, I was up on maybe this stage even in this room, [at a previous conference] when we were talking about target-date funds, and we did get a question on exactly that. It's early 2010, you guys are using the index, it's so much in government debt, what do you think about that?
I would just say we're always very hesitant to second guess the markets, and second guess the decisions of all the folks in this room, and all of their clients about what the relative valuation of these assets are. That can go either way, and obviously what happened the last time we had that conversation is the unexpected decline occurred, so that can happen again. I think it does come back to what my colleagues have said here about the role of bonds in a portfolio for retirees or for anyone else. They are there for safety; they are there for diversification.
The search-for-yield thing is very much like trying to find more hours of daylight in the day, and as Bill says, there are safe assets, and there is a yield that goes along with that. It will fluctuate over time. It's not quite as predictable as the seasons. But it does move over time, and to some extent we are unfortunately in the situation of having to accept that. And so that, sort of as a final point, gets back to what are you trying to do for retirees, and I know at Vanguard when we're talking about planning advice to individual clients we are still very much focused on a total-return approach and having people think about their portfolio and its overall risk, its expected rate of return over time, and how to manage that, and not to get too caught up on some of the accounting issues around what's income and what is capital gain.
That, I think, is one of the biggest value adds that an advisor can bring, to help people to try to understand that, and add that advisor's alpha, if you will, of talking through why you are still in stocks and why maybe in your situation you need to get past your age in bonds, maybe you need to be more aggressive or more conservative. I mean, that's the job of the folks in this room.
Benz: Sue, I want to follow up with you on that and talk about how you educate your clients on that total-return issue. I know that we all have people in our lives, whether clients or otherwise who very much anchor on that current income. They want their portfolio to deliver the 4% yield or even something less possible. How do you work with clients to talk to them about growing their capital and maybe occasionally tapping that capital?
Stevens: Well I think that is one of the things that when you first work with a client, they may come in with a perception that "I want to live on the income of the portfolio." And I would say to most people today that it's just not possible. Income is really low. We have to think about what you need during the rest of your lifetime, and what's going to get you there is total return, not income. So we spend a lot of time talking about the difference between yield and appreciation or depreciation, and still we'll have people come back saying, "Well, you know, what's the yield on that?" And I'll say, "2% or 3%, but the total return is like 8% or 9%," depending on what you're talking about. Sometimes it's still 2% or 3%, but I think it's important to keep coming back to sort of the basics and educating people about how you're going to get there, and I'd say one of the ways that we can best demonstrate that is with some of the software that we use.
So we'll show people cash flow projections. I'm sure a lot of the advisors in the room are doing that too, and you can model exactly what they're doing. I think one of the things you especially want to get across is to lower your expectations for the return on the portfolio. I think that's a huge job that we have right now, and when I look at Jeremy Grantham's work, I'm always looking at what do think the projections will be, or I look at what Jack Bogle has been saying about asset-class projections. So if I think in general I'm trying to educate clients that stock returns are probably going to be between maybe 5% and 7% for some time to come, and bonds are going to be more in the 2% to 4%, range. So, if you have a balanced portfolio, we might be 4% or 5%, but if we're in a secular bear market--and again there is great information out there by Bill Bengen in articles he has written, I use that chart that shows a picture of the secular movements over time, both bull and bear markets--I think, if you set the expectation that that's climate that we're in, we're going to do the best in that climate that we can, which might be a 4% or 5% return for a while, until we get set up for the next bull market, which comes with some regularity. We don't know when that will be, but it will come.
Benz: Bill, how about TIPS as a percentage of a fixed-income allocation? How should retirees or advisors go about setting that TIPS allocation as a percentage of the fixed-income portfolio?
Bernstein: Well, TIPS are very peculiar asset class. I see TIPS as liability matching portfolio in a perfect world, which we don't have right now. Ideally, when you retire at age 60, or 65, or 70, you should have a ladder of TIPS that defeases your real liabilities as you get older each year, theoretically you'd have a rung in each year, and you would take your living expenses out of that.
Now, I say TIPS are peculiar asset class because they are absolutely riskless in a real sense when held to maturity. There is no other asset class you can say that about, which is why they are the ideal defeasing asset class or asset for the individual. But on the way there, they can be very risky, as we found out in 2008. I mean, the longest TIPS I think had a maturity at that point of 24-years and it lost 24% of its value top to bottom; that's the reason I don't like TIPS bonds for individuals. If you're going to own them, just own the darn things outright in a ladder and don't pay an expense ratio, even if it's a Vanguard expense ratio.
Benz: John, I want to follow up with you because I know you hold TIPS in the target-date products. I'd like to hear about how you set those allocations, and do they change as a person progresses toward retirement?
Ameriks: They do change as a person progresses toward retirement. In general, as you reach the retirement date, about five years before, we'll start to introduce TIPS into the portfolio, and it becomes 20% of the allocation in the target term and income funds. TIPS, I think, play a very important role in that portfolio. We've always talked about them because of their unique role as inflation protection. They are the only thing that can truly hedge CPI inflation because of the adjustment mechanism that's built into them. That does come along with what Bill mentioned though. Just what he was talking about made me think through when we talked a little bit about income and the retiree focus on income.
There is a lot of that, but boy, when the current value of what they are generating income from moves around, they also seem to pay a lot of attention to that, and this is exactly the issue I think that Bill's identifying. The TIPS index funds probably have a higher duration than many people expect. We always get questions at Vanguard when the TIPS return is less than the rate of inflation, because individual clients will say, you told me it was inflation protected, why does it have a negative return? So, you've got to take them through that.
At the same time, I think, you've got to step back and do a little bit of education about the laddering issue. When you look at a ladder of bonds, you're getting a portfolio of bonds. And depending on what you're trying to do there, you may end up with something that looks an awful lot like a Vanguard index fund that has an intermediate duration, and there you've got to think very carefully about the expenses that you're paying and incurring to manage that ladder versus what Vanguard or anyone else is charging to supply the fund. So, there are some trade-offs there, as well.
TIPS are very, very important, but I think we're doing a lot of education now to make sure that people understand. To me, the biggest things right now are that people need to understand where rates are now, what the word duration means, and what could happen in an environment where rates increase. I don't know that that means we need to be stampeding clients out of fixed income at this point. We need to understand what those risks are and recognize that there are trade-offs, but we really are out there trying to make sure everybody gets it, that if rates head the other way, you are going to see big changes in current value. Just be ready for it.
Benz: So also in the realm of inflation protection, looking at Jeremy Grantham's starts, you saw all the bonds going into the red on a real basis. What other ideas are out there for adding that element of inflation protection to retiree portfolios?
Ameriks: It does depend on kind of what you are talking about; this is the hardest thing for us. We've had a lot of discussions around inflation protection. And what do we mean? I mean we did one of our papers that Christine mentioned is on inflation hedging and the role of expectations. When you think about inflation, you've got to decompose it. There is an expected component of inflation; there is an unexpected component of inflation, and the hedging issue is usually around that unexpected component, which fundamentally it tends to be a short-term phenomenon. It's something that's three to five years. If you look at 20-, 30-year horizons, inflation and expected inflation are almost the same thing.
When you're talking about hedging, it's a short-term issue, and I think that's where the client objectives get a little fuzzy. What is this client trying to do? Are they trying to grow purchasing power over long period of time? Then we are not talking about inflation hedging. We are talking again about total return in a real sense, and you think about bringing assets like equities or other higher-returning assets into the portfolio. If you are looking at hedging, I care about exactly what my income is or my rate of return is relative to inflation. You've got to look back again at something like TIPS and accept the fact that over the long-term your purchasing power may actually decline even though the return pattern is going to match inflation.
Benz: One other component of inflation protection that has really become popular in the past few years has been some element of commodity exposure, and I'm wondering, Bill and Sue, if you can address your thoughts on the role of commodities, if any, in client portfolios and also if so what type you might think about using? Is it direct, indirect, what is it?
Bernstein: OK, commodities funds. Back in the day 40 or 30 years ago, a commodities-long exposure was a wonderful way to hedge that inflation and to earn a positive real return. Why was that? Well that was because the counterparty that you were dealing with was Farmer John, and he was afraid of deflation, or it was the CFO of Standard Oil, who wanted to protect himself--it was always a "himself"--versus a fall in price. So you were basically providing protection for people who were afraid of deflation. So you earned a positive rate of return because you could sit back and watch for any amount of backwardation for the forward prices to fall significantly below the spot prices, so you could earn that role.
Well, who are the big players now? The big players now are PIMCO and Goldman Sachs, and they're definitely afraid of inflation. People have been shocked to find over the past 10 years that a commodity fund with a commodities strategy, with a managed futures strategy, has actually had a negative real return for that reason. Think about it, the fund with, I think, the longest track record, the PIMCO fund, has had a real return of not much greater than zero at a time when the price of any commodity you want to look at, as Jeremy Grantham just pointed out, is about triple. So there's something wrong with the vehicles, and that is that you are the patsy in the room when you buy one of these funds.
If someone wants to ask another question, I'll tell you what I really think.
Benz: Sue, how about you?
Stevens: Well, you know I think all of us have been looking more at alternative types of assets during the last few years, and commodities would, for me, be one of those things that I would look at. I think Jeremy Grantham has made some great points and other people like him that with things changing in China probably the role going forward of commodities is not going to be what it's been in the past. So I probably would not be using them particularly for an inflation hedge. I would look at alternative assets, and I think one of the things that's been interesting about exploring some of them is they don't always work the way they are advertised. So you put them in there, and I think there have been many disappointments. I mean even something like timber, there's a couple of exchange-traded funds out there now that will focus on that area, but I think they dropped by 20%-30% last year. So that's not a perfect area. You have to be really careful. I think I would go back to more of a classic way of looking at hedging inflation, which is making sure that you've got some stocks in there. You've got maybe some precious metals, not a lot, but again I'd put that alternative in as a way of potentially hedging.
When I look at my portfolios in general I can say to a client about 60% of your portfolio is inflation-hedged, and that's because it's either stocks or other things, TIPS included. And maybe one other thing to throw out there would be the role of inflation-adjusted annuities. So that's another thing for people in retirement. Annuities is whole other can of worms that I'm sure you're going to get to. But now they do have inflation-adjusted annuities, and I go to Vanguard, go through their portal there.
Ameriks: That was exactly where I was going to go with this, as well. Just a couple more words on commodities; that expectations idea that I talked about is really important, especially with commodities funds now. These funds are using futures in general, there are some physical funds out there, but most of them are using futures. We know from, again, what happened a couple years ago, a lot of clients, a lot of brokers, and maybe even some advisors are not as familiar as they need to be about the role of expectations there. If the futures market expects prices to increase, that expectation is built into the price. Your clients are not going to see what they think they are going to see in terms of oil going from where are we now $78 per barrel to $110. If the market thinks it's going there, that's priced in, and that's what Bill is talking about with this real return issue. That what happens in the futures markets looks very different than what happens in the spot markets. I think that's the big danger in talking about these things as inflation hedges.
There are lots of other risks in a commodity exposure, and yes, there is a very attractive short-term correlation with inflation and commodities prices. But there are lots of other things that move the commodities markets around, and just as with TIPS, they're going to be environments where inflation goes one way and commodities prices go the other way, and that's a very difficult conversation to have with a client that you've been telling the commodities are their inflation hedge. So I think, when we talk about hedges, we really do have to look at things that hedge inflation. And those things are indexed to inflation over time. That can be TIPS; a buy-and-hold TIP is going to do what people expect it to do. It won't have the sensitivity to real rates. An inflation-indexed annuity will do that as well, will step up with inflation. Again, as somebody else said, I think, it was you, Sue, there is always risks out there, and with the inflation-adjusted annuity that can be the risk of the provider being able to deliver on a promise for many, many years. So, nothing comes with absolute guarantees. There is always an asterisk.
Benz: I just want to pause there because we are using the same process for questions that we've been using these past few days. So if you do have a question, one of my colleagues, Josh, will be walking around, another colleague, David there, will be collecting cards. You can hand off your card, and I hope to have this panel tackle them. But let's do spend a couple of minutes here talking about annuities. I could tell that Bill and Sue, you both have something to say on this topic. But my question more broadly about any sort of fixed annuity right now is just how the interest-rate environment is so lousy in terms of the payouts that you're able to obtain. What's your take on that question, and how should investors and advisors navigate that issue of the unforgiving interest-rate environment?
Bernstein: Before we get to annuities, just 15 seconds. Short bonds are also a pretty good, historically--I know it doesn't seem that way now--but they're historically an excellent hedge against inflation because you get to roll them at a higher rate. And if you get unexpected inflation, you're going to get a positive real return. That's historically happened in a number of countries, most spectacularly in Brazil where when the inflation was finally brought under control, businessmen were angry because they had to go back to making things, whereas before they just were able to take their capital and earn a 10% risk-free rate.
The other thing, of course, is that long-term stocks were a pretty good hedge against inflation. They're not a good hedge short term, but long term, which is what you should be concerned about, they are a pretty good hedge. Now, as far as annuities go, I think immediate fixed inflation-protected annuities are a superb vehicle. And I think the major choice that anyone faces as they approach retirement is how much they put in annuities. The alternative to an annuity is the TIPS ladder, all right, and what are the pluses and the minuses?
Well, the big minus with a TIPS ladder is that you could run out of money, all right. And of course, yields right now are very low, so you'll have to wait to probably average into them. So, yes, you can run out of money. Now, the positive, you can avoid that problem with an annuity through monetizing your mortality, to use the euphemism, in other words waiting for the people who are buying it along with you to start pushing up the daisies.
But the risk, the real risk of an annuity, of any inflation-adjusted annuity, a commercial one, is that you are taking horrible credit risk with the companies that issue these things, and I think that we have a very unstable financial system; it has not been fixed. We had five or six banks that were too big to fail; now we've got three or four that are too big to fail. The system has become much more unstable. So I think you have to balance those two risks off; one with using a TIPS ladder, the other using commercial annuities. And then the last thing is what I talked to you about yesterday, Christine, which is the real free lunch in the room, which is deferring Social Security until you are 70. There is no annuity that you are going to get that will have that kind of return. And if you have to max out your credit cards from age 69 to 70 to get there, do it.
Benz: Sue, how about you? The role of annuities in client portfolios--is it something you are using, or are you waiting until interest rates improve?
Stevens: Well, I like the idea a lot in theory. I think the problem is when you go to buy an annuity right now, the rates are so low and you are locking into that rate for the length of the annuity that I'm not doing it. People will come in as new clients that have annuities, and I'll do 1035 exchanges typically over to Vanguard to figure out how to get it at a lower cost because I think that's one thing I can do for them.
But I'm waiting. I think the day will come when rates are up and I will start to use more fixed immediate annuities with an inflation component, but I'm not doing so much with that now. Maybe one other thing to mention is along the same line, how do you get people through this time when there is not as much income. T. Rowe Price has done some interesting new research in a program called, let's see, it's something about delayed retirement…
Benz: Work longer…
Stevens: And it is interesting. Have you seen it?
Stevens: And one of the things that they're saying is that you can either work it and then stop working. You can keep working all the way till you are 70 and contribute to your plan, or you can find this middle ground, it's called practice retirement, practiceretirement.com. You find this middle ground which seems practical to me, and that's kind of where I always am is practical meets academic. People keep working a little longer, which is what they're seeing out there now with the baby boomers, but they stop contributing to their retirement plan in their 60s. They keep the income stream going for an extra five or six years and give the retirement plan a chance to grow that much longer, and defer Social Security, so that by the time you get to 70, you're kind of set up a little better to handle this. Hopefully as we go along, things will get better.
Benz: Right, and I think that T. Rowe Research showed that the additional contributions once you hit a certain age aren't all that impactful, so that's part of the thinking. So, a very topical question here, this person would like to hear the panelists' thoughts on longevity insurance. A fixed deferred annuity.
Ameriks: Yeah, I was just going to pick up a little bit more, and I'm glad we talk about annuities and Social Security in the same breath because they are similar things. Longevity insurance is yet another form of that. I think, this whole discussion is really around how much longevity protection do people need, and it is very important for you as advisors to understand how much longevity protection people already have. They have it in various forms; we've talked about Social Security. There is also some degree of longevity protection in the form of the Medicare benefits that people are receiving. As costs are rising, and that might be less protection in declining value, sort of like a nominal annuity if you will; it gets eaten away as inflation rises every year, and there is some risk around it. But it still is a benefit that comes every year that someone's alive; they are entitled to collect their Medicare benefits.
One other thing is housing. I mean people have purchased a home, and it provides housing services. There's a maintenance cost to that, but that's going to last as long as people own it. So there are a variety of ways in which people already have inflation protection and annuitization. A third way are pensions, and I don't know about you, but at least with this cohort that's retiring, people in their late 50s through their 70s, there are many that are still coming into retirement with some degree of pension income. And that's going to continue for many years. The transition to a world in which everyone has 401(k) plans and what they've been able to save on their own is going to happen, but it's going to be a very slow transition that occurs over many, many years.
So, again, as advisors it's your role to think about all this and answer the question, well, does my client need more longevity protection and more insurance around not making it to the end of life. The purest form is what you mentioned, longevity insurance, which is a form of an insurance contract that I know the federal government and the [Obama] administration is trying to encourage. They've proposed some new regulations so that that would now meet required minimum distributions and you could use it as part of an IRA, which you couldn't do before, if these regulations go through. But it means giving a lump sum today, not having anyone collect any benefits at all until they reach a very advanced age, say 85 or 90, well past their life expectancy, and then the insurer would start to pay benefits. And what it really does is it leverages the monetization of mortality that basically there will be a large fraction of people who won't make it to claiming age, and the benefits that the insurer would have had to pay to people who were in claim will go to those people who live a long time. So it really does leverage the insurance arrangement. It also allows an advisor to manage the vast majority of the assets over the time before the longevity benefit kicks in. So it's very attractive. Still, it's going to be a very difficult thing to talk to clients about. [They might say] "I've got to give $10,000 now, and I'm not getting anything for 20-years? And if I make it 19-years and not 20, I don't get anything?" It's still going to be hard.
Bernstein: The problem with longevity insurance is a practical issue. A lot of academics talk about it as if it's an off-the-shelf product. I don't know how many of you have gone out there and actually tried to buy it for your clients. But it's very opaque. It's actuarially very unfair. You actually have to be an actuary to understand what you're actually getting. And there is no inflation protection in any of these products that I'm aware of. So, you're subjecting your clients to significant inflation risk, and there is industrial-grade credit risk because you're giving this enormous amount of money and the potential for 100% loss is very high at a time when your clients can ill-afford it.
Ameriks: I agree directionally with all those points, Bill. I mean, the nice thing about longevity insurance is that it's not as big an upfront cost as an immediate annuity now. But the issue you're raising is exactly right. Insurance has got to pay off, and that's a huge risk.
Bernstein: And you can't buy joint ones, that's another wonderful thing about them, as well. So, it's really like communism; it's wonderful in theory.
Ameriks: It's very underdeveloped, and so it's not going to be the silver bullet to any of these things. But, again, like I said, this is a transition that's occurring over many, many years. So these things are going to start slowly. It's kind of "watch this space" kind of thing. I can imagine that a lot of clients are going to walk into your offices and want to know about this, but there will be some.
Benz: Another question, and we won't stay on annuities for the whole rest of the panel, but a question here. "Given the low interest-rate environment and equity market volatility, why not utilize a guaranteed minimum withdrawal benefit, living benefit, for example 5% for life within a variable annuity for 30% of a portfolio?" We'd like the panel's take on that question. John, I know you've done [some of this]?
Ameriks: It's one word: "costs." When we look at what that costs and look at what the benefits are, if what Bill had to say about longevity insurance frightens you in terms of having to know the details and how it's structured and what the benefits are, boy, with guaranteed lifetime withdrawal benefits, you'll have a nightmare about that one because there are so many different products with so many different features. How does the step-up work? What are the restrictions on the portfolio? How is the insurance company taking care of the market risk there?
Look, we all know the markets are not perfectly efficient, but they are pretty reasonable, and there's no free lunch in the derivatives market. If someone is paying to hedge stock market risk, there's a cost that's going with that, and there's another way of getting risk out of a portfolio, which is just allocating to bonds. It's a little more straightforward and maybe a few less traps for people that are using it.
Benz: Bill, a question here for you. "How low is the duration of your portfolio? I know we have talked about how you like to keep things pretty short. How short is short?"
Bernstein: Somewhere in the vicinity of a green banana. It's pretty short. It's less than a year.
Benz: Another question. "I would like to hear from all of the panelists on, are you using any nontraditional assets or approaches?" Sue, you touched on a few that you are using. Bill, you're shaking your head. And John, I know that Vanguard has been pretty shy in general about not--I wouldn't say shy, but you've been reticent to embrace. . .
Ameriks: With one exception--the managed payout funds that Vanguard offers. In those funds, they are active funds, and you guys I think you know Vanguard because of our role in ETFs, you know us for our indexing. But we also have an active set of funds, and one of those is managed payout, and there we've got some ability to use some of the asset classes that we're talking about in an active context. And so, we look at things like a market-neutral fund as an active fund. Market neutral just takes the short constraint off of an active manager.
So, for us in the context of managed payout, market neutral is an investment vehicle that's run by our quantitative equity group that follows the similar sort of models and strategies as our other quantitative funds. It's just it can also short instead of just underweight what comes out of those models.
For me alternatives are not an asset-class level discussion, they are a manager-selection issue. You have to know what you are talking about; you have to know the specifics and the dangers there. Quantitative analysis has limited application when we are talking about manager selection, just because the data is not as powerful as we'd all like it to be and the qualitative issues are paramount. You got to know what the strategy is. What's the theory? Are you comfortable with the people and the process that are employed?
Bernstein: You've only got four bricks. The world by definition has to be a 100% long stocks, bonds, cash, and commodities. So how you mix, if you are going have a hedge fund or an alternative or someone who is managing futures, you have to have some mix of those four. So how you get a noncorrelating asset out of that is something that I don't understand.
Benz: One other question, and it's a big one, I think, we could spend the whole panel on this, but I'd like to spend a little bit of time talking about withdrawal rates. This has been a rich area of research for a lot of folks. I think it's one of the most rapidly changing topics; you just seemingly see a new research piece every day. I'd like to talk about, let's start with you, Sue, and talk about how you as a practitioner approach setting client withdrawal rates.
Stevens: Well, I think, it's incredibly complex. I think I have read every study from the Trinity study forward. A lot of people are doing a lot of good work on it, such as Jonathan Guyton and Bill Bengen, people like that. I think, some of their views have changed over time, and I think 2008 tested a lot of those assumptions. I think the assumptions are the key to the whole thing because every time you look at one of those studies, you really have to understand what's the asset mix they are using, how many asset classes are they using, do they consider taxes or inflation…
Benz: Time horizon.
Stevens: Time horizon. All those things really go into day-to-day managing of a client's portfolio. So to me you want to think withdrawal rates. A kind of a rule of thumb, I've always been a little on the lower side than maybe some of the people that go a little bit higher because of things like fat tails and some of the other things that can come along, I'd rather just be a tiny bit more on the conservative side of that.
But I know there has been a lot of criticism of Monte Carlo and the retirement programs that are out there. I still think they have a role, but I think as the advisor the most important thing you bring to the table is your wisdom and your judgment. I think it's helpful to run [the programs]. Some of them have a separate page where you can see the withdrawal rates, and they change over the time. I think that's one of the things that Bill Bengen is now talking about is you got to have some flexibility in here, whether it's a floor and a ceiling or how you are going to adapt along the way. But I think flexibility is key in trying to help your clients get from here to wherever it is ultimately we're going.
Ameriks: We're looking at those studies. It's something, I think, we're all doing in light of what's happened. There seems to be new data every year, and we can rerun the models. I look at the withdrawal-rate studies. I think they're very useful tools for helping to set client expectations, to try to explain why you're going to tell them 4% or some number around that is what you need to be thinking about entering retirement. The Monte Carlo tools, historical analysis, all of that can do that very well.
But as Sue said, it's all about the assumptions, and when you dig into what the assumptions for any of these analyses, they are so restrictive and so unrealistic in terms of what it implies about behavior over time that you just have to be really careful with your clients to make sure they understand this an illustration. This is not what I plan to do with you every year. Every year I'm not going to just automatically raise your withdrawal by whatever inflation is. We were saying this before, I don't know how many of you had clients that came back at the end of 2008 saying, "I'm ready to take my inflation adjustment. Let's increase withdrawals this year." Most people were the other way around. They were saying, "Well, how bad is the cut going to be?" People do I think recognize that they have to be sensitive to what their resources are over time, and that's got to be built into the process. And that's why we are, I think, big fans of talking about the 4% [withdrawal rate], getting expectations set, and then thinking about things that are more proportional over time, thinking about a fraction of a portfolio. With the payout funds I mentioned, we smooth what we are doing. That's an average of the balance and a percentage of that that gets spent over time. In practice that's something that you've got to talk about with clients. Endowments and universities have done this for years. There are spending rates that they use, and I think that kind approach is ultimately how the real world works. Then we are all trying to figure out what's the best way to kind of get across all of this complication to clients so that they understand what it is that we are doing for them.
Benz: So John, in the case of the managed-payout funds you use an average of, is it three years, five years?
Ameriks: It's a three-year rolling window in terms of the net asset value of the fund. There is a fixed proportion of that that's reset every year, and that's what will be spent over the course of that year. Then we see what the performance was, and then we'll reset the rule again. That's very systematic. That's what you are going to get with the fund. And it's a fund, and I would expect that advisors could look at that. Maybe there is a role for something like that with some clients, but in general, I'd expect that the rules that you would use might be a little more tailored and might better fit the needs of your clients.
Benz: Bill, anything on withdrawal rates?
Bernstein: I guess I'm the wild-eyed optimist here. I think it really depends upon what your clients' actual burn rate is. If you have a client that has a 1% burn rate, and stocks yield 2%, and dividend payouts rarely fall even during the worst economic crises by more than 50%, then that person could be [invested in] 100% stocks.
On the other hand, if the person only has 25 years of living expenses saved up, then by definition they should be buying something that looks like a TIPS ladder or an inflation-adjusted annuity because a 4% payout is what those things will pay at age 65 on a joint-survivorship basis. I guess what I'm saying is that your safe withdrawal rate is somewhere between 4% and 1% depending upon what the burn rate is and what your asset allocation is. As important as the Bengen and the Trinity studies were, you have to realize those were done with historical stock and bond returns, which I think in this day and age are wildly optimistic.
Benz: The last question I would like to tackle is this idea of bucketing, which has become wildly popular among our users on Morningstar.com. It's intuitive. But I would like to hear from you guys about whether you are in favor of the bucketing strategy. There are obviously lots of different variations, numbers of buckets, and so forth. But is it something that you would advise people to think about when constructing their retiree portfolios? Sue, you say, you don't use buckets?
Stevens: I don't. I would encourage anybody who is kind of struggling with how to think about spending, to use whatever works for them. So, if buckets work for them, great. As an advisor, no. I'm thinking about total return. I'm thinking about where we're going over time. But if somebody came to me, and lots of clients will say to me, "I read this thing that says I should have five years expenses put into something safe." We do that. So, that's an easy thing to answer. Do we have a bucket? I guess we do. But I don't think about buckets. I think about the big picture and the small picture. I'd say a huge amount of what we do in our practice is making sure we stay about three months ahead on cash for everybody so they have whatever they need. So they don't really need to think about buckets. We just have to think about where we take the money, the most advantageous place to take something to keep filling up that cash pool. That's more what we do.
Benz: So, how much cash do you aim for, for that cash pool, that bucket number one?
Stevens: Very little at the moment because it pays zero. I try to stay about three months ahead if [the client is] in a spending mode, and then I would keep my normal allocation in fixed income. I might think about how much do I want in really short-term bonds versus intermediate bonds if I've got somebody that's drawing down assets, but I'd think about that anyway.
Benz: So you sort of tee it up in the fixed-income portfolio? You've got your short-duration assets, and those are what get over to cash?
Stevens: Yeah, though I'm very careful about how much I have super short right now. I'm not quite the green banana, but I'm more of a four- to six-year duration.
Benz: Are there any short-term products that people like that you're using for example for that next step beyond cash, that you think the risk/reward profile is good?
Stevens: Yes, there are several of them out there. I think MINT, PIMCO's ultrashort fund is kind of a notch above cash or a low-duration type of product, PIMCO Low Duration [is another fund]. There are lots of them out there that I think would work fine for that kind of a thing.
Benz: Well, I think, we will have to end it there. Lots to talk about. Thank you very much to our panel.