For Retirement Portfolios, 'Immunize Then Optimize'

Author and investing expert Michael Falk joined The Long View podcast this week to discuss the state of the investment landscape: how investors should approach bonds in a low-yield world, whether the industry has overdone complexity, and whether asset allocation has become a commodity. Falk also expounded on how retirees and pre-retirees should be operating in this environment and the steps they can take to ensure the success of their plans.

Here are a few excerpts from Falk's conversation with Morningstar's Jeff Ptak and Christine Benz.

Covering Two Sets of In-Retirement Expenses

Ptak: Can you give us a couple of examples of how you would simplify what passes for conventional wisdom right now when it comes to retirement planning in the industry today?

Falk: Many years ago, I coined a term, you should immunize before you even try to optimize. And what I'm referencing here is, take your entire spending plan, everything you spend money on every month, and divide it into two pieces: fixed spending that happens no matter what and fun or aspirational spending.

Let's just start there. Let's get a handle on that. Then let's ask a couple of questions. To what extent will Social Security or any pensions you have--let's just look at those two tools, fixed guaranteed life payments--to what extent do you have coverage of your fixed required monthly spending? If you have coverage, then we know that your fixed spending is immunized. The goal here then, if it's not, is to ask to what extent should we be looking to annuities, or laddered bonds, or reverse mortgage to immunize that fixed spending. Because then once we do that, we can bias the portfolio heavily toward equities, or other risky assets, for the aspirational spending because even if there is a bad year, you can still cover your costs. You don't have to worry about liquidating at a bad time.

Benz: You referenced three possible solutions for that immunization: the laddered bond portfolio, or reverse mortgage, or some type of an annuity product. Those are complicated products. How would you suggest investors proceed in trying to figure out which, or which combination of those solutions, might make sense in their situation?

Falk: Christine, that is where we can only get so simple. With annuity contracts, find an annuity expert. The complexity in these things that seems straightforward is real. Laddered bonds, well, here is simplicity, given interest rates today, or expected in the near future, maybe we don't even have to think about that choice. Reverse mortgage, now this gets into other bequest aspects of someone's estate plan. And can they stay in that house as they age? Are they going to have to sell it? And it gets into a different conversation then that connects with retirement planning that has to then get into the estate planning side of the dialogue.

Behavioral Impediments to Good Retirement Planning

Ptak: We wanted to talk about another dimension of retirement planning, which is the behavioral dimension. Behavioral finance is a key area of interest for you. What's your take on the behavioral aspect of retirees who are averse to living on anything but income from their portfolios? They don't want to sell anything, even if it's appreciated a lot and is adding risk to their portfolios. First, do you think this is a problem? And, if you do think it is, how do you think advisors can help change their clients' minds in these instances?

Falk: I think one of the greatest continuing education or continuous improvement steps that advisors can take is learning about behavior and psychology generally. For retirees, and please people, start to try and understand that--the fear is that they're going to run out of money before they run out of life. So, anything that connects to that fear is something that you will need, or it would be beneficial, to counsel them on.

Benz: I would guess it's fairly common that advisors encounter clients who say, "Just build me a portfolio that kicks off this 4% income distribution that I need." How do advisors push back on that? Assuming that they think that idea is ill-advised. Do you have any thoughts on that?

Falk: Well, it's really simple. If you have immunized, Christine, we don't have to bother with that. We don't have to take the risk of reaching for yield in a low-yielding environment, because we don't need a "4%" yield; we've covered the fixed expenses. Now, we can talk about, based upon your prior calendar year's rate of return, what rate of liquidation can you take from your portfolio--be it yield or capital gains, it doesn't matter--to enjoy the current year. And I have created a three-part rule for how you look at the prior year's return. If it's above this, if it's below this, if it's in between--how much you can spend out of your portfolio to have a great year of spending.