Risk Control Measures for Retirees

Christine Benz: Hi. I am Christine Benz for Morningstar.com. Managing risk while you are an investor is important all the time, but especially so for retirees. Here to discuss that topic with me today is Mark Balasa. Mark is a principal for the firm Balasa Dinverno & Foltz. Mark, thanks so much for being here today.

Mark Balasa: My pleasure.

Benz: So, Mark, the key risk that retirees face is longevity risk, outliving their assets or having to recalibrate their standard of living during retirement. Can you talk about how you coach clients and how you work with clients on managing that longevity risk to make sure that their nest eggs last?

Balasa: Sure, it's a great question and it's a very timely question, obviously, with what's happened in the markets the last couple of years. The worst thing possible for someone going into retirement, is to have the market go down, which is what we've obviously seen. So, outliving your money is a big concern for a lot of people.

Some of the solutions to that question, are things that people can control, and of course, many of them are things people can't control. So, a great example, rising interest rates, no one can control them, but you try to build your portfolio and how you invest your money to offset that risk.

An example on things where you can control outliving your money would be, understanding how your money will play out over time. And so that means, essentially stepping back and looking at some numbers to see where you are at. Do you have a 150% of what you need or do you have 50% of what you need.

Once you understand that, then people, I think, make better decisions about how to spend their money. Again, one of the things you could control. Minimizing costs, minimizing taxes, again, things you could control.

On the investment side though, I think, one of the concerns that I see when people come in is that they feel that they have to have just current income to live off of.

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Benz: Right, versus total return and tapping that principal periodically?

Balasa: That's exactly right. And that's especially acute with people that lived through the depression or know people that did, and so, they have a very narrow focus in terms of how they should invest their money and what it means to have a return. But as you correctly said, we encourage people to broaden their view and look at total return, not just current income. And if you can do that, typically, you can increase the return, which again helps your money last and again as an offset to outliving your money.

Benz: So, you coach them on how it's very risky to be looking to your portfolio for income these days, because you have to venture into some pretty junky stuff to get that kind of yield or riskier fixed income investments to get that yield that you need.

Balasa: It's exactly right. I mean, one of the things I'd say kind of tongue-in-cheek to some people, especially, if they are very focused on fixed income is, if you invest, for example, I'll take an extreme, in nothing but CDs in today's world, that's kind of like going broke safely, right, because your money quickly erodes over time because of inflation.

Benz: Right. So, right now we are in a period where there's a distinct threat that rates – interest rates will go up. And I'm wondering if you can talk about how you manage pre-retiree and retiree portfolios in the face of that threat?

Balasa: You bet. Again, I think, a lot of people in the economics world and others feel that the concern for rising interest rates is not an immediate threat. It's something a little bit more intermediate. If you can think about 10% unemployment or close to it, et cetera, it's not an immediate threat.

So for us, probably for the next six to nine months, maybe even a year, we're looking actually almost at intermediate bonds as opposed to really short-term to help insulate against rising interest rates, because the normal knee-jerk reaction would be to shorten duration...

Benz: Right.

Balasa: ... to preserve principal, and if indeed, rising rates were imminent, that would be great, but right now, you can get enough extra yield for intermediates versus short-term that even with a little bit of loss of principal, you're still ahead of just short-term bond portfolio.

Benz: Right, so one other thing I wanted to talk to you about Mark was, this whole bucketing approach for managing retiree portfolios. So the idea is that you carve out a safe sleeve that you draw on for current income and then maybe you have some other buckets that you draw on down the line. Can you talk about whether you use such an approach in retiree portfolios and how retirees should think about adopting such an approach for themselves?

Balasa: We do use it. We use a modified version of it. I think in terms of psychology the behavioral finance, it's very effective, because people could look at some part of their portfolio, let's take the cash piece or the bond pieces you just described, and look at that with great comfort that that's not going anywhere if the market goes up, 200 or down 500.

And so, although you still come back to some stock bond, cash, real estate mix, let's say in the aggregate, if you break it down in buckets, So people can say lookit, I've got – I'm going to pick a number that's pretty typical in our firm – a year to 18 months worth of living expenses in cash or very short-term bonds, they know full well the world can go all over the place in 18 months and it has no impact on them.

Then the next bucket, as you described, would have bonds, their bond portfolio, and that could be anywhere from two years to 10 years, right? Depending on the allocation.

And then finally, you have equities, and we look at those, and say, lookit – that's going to give us that real return we talked about earlier and help us against inflation, and if that bounces around that's okay.

The other way of bucketing is helpful is if people have a lot of money, relative to their needs. And again, people have high needs and low needs for current income, but bucketing helps when it comes time to thinking about gifting.

So if you can show a family that look we can put the balance of your life's income needs in short-term very – let's say, stable municipals and the rest of the amount is going to kids or charity, can be more aggressively invested, that helps them make some decisions.

Benz: It helps them physiologically compartmentalize their various assets...

Balasa: Yes, instead of having everything very short-term and conservative, to broaden it out.

Benz: Well, thanks Mark. Great insights. We appreciate you taking the time to be here.

Balasa: My pleasure.

Benz: Thanks for watching. I am Christine Benz for Morningstar.com.