A Common-Sense Approach to Retirement Planning

Today's retirees and preretirees face multiple challenges, including still-shrunken principal values following the 2008-09 bear market and rock-bottom interest rates.

To get an expert perspective on these important topics, I recently sat down with Harold Evensky, president of Evensky & Katz Wealth Management. Morningstar managing director Don Phillips once called Evensky "the Dean of Financial Planning," and for good reason: Evensky marries the wisdom of a topnotch practitioner with a focus on cutting-edge research.

Part I of our conversation, focusing on asset allocation, appeared on Morningstar.com last week. (Do yourself a favor and read the many insightful comments below the interview.) Part II, about planning for retirement, follows.

There's a lot of concern about the prospect of higher interest rates and what that could mean for fixed-income portfolios. How are you thinking about that issue?
With a fair amount of concern. We do expect higher interest rates. Our concern is that they could peak in a very short period of time. In terms of fixed income, we invest in fixed income to preserve principal. We invest in equities to make money.

So we've always had a focus on preservation of principal in the fixed-income portion of our clients' portfolios. Our average standard in a normalized world is a credit quality of A and a duration exposure of about five years. Now, we ladder our portfolios, and even if we use funds we ladder by using funds of different duration exposures.

But for quite a few years we've been more defensive so that our average quality has been AA and our duration exposure has been around four years or so. And we've moved that down to about three and a half years. So that's the primary positioning in fixed income in anticipation of higher rates. Now, there's a cost, and we've been defensive for a fairly long time and given up some extra yield because we've stayed high quality and short term.

The other concern is if rates go a lot higher and they pick up quickly, that's also going to have a negative impact on the equity market, too. There's only so much you can do in terms of trying to predict the future. But that's the reason we're such big believers in diversification and so skeptical about any significant tactical strategies. If you're right with a tactical move, you look brilliant. But there's way too much risk. I would say there's a guarantee that the timing of some these brilliant tactical moves is going to be wrong.

What are your thoughts on bank-loan funds? I've been hearing from a lot of readers who are looking to them as insulation against rising interest rates, but it's hard to forget how badly some of them performed in the bear market.
It's something that we've looked at, and intellectually, bank-loan funds make sense. But given what's happened in the last few years, our lack of confidence in being able to understand or evaluate the underlying quality has made us very hesitant to go into any investments of that type.

Burned once, shame on you. Burned twice, shame on me. So if there's anything sort of new or special or different or clever, we're extraordinarily skeptical and careful.

So let's segue into annuities. Based on a previous discussion, it sounds like you are very bullish on single premium immediate annuities long term as a part of retiree toolkits. But right now you're saying hold off, because of the interest-rate environment and the relatively low payouts that you'd earn?
Correct.

So how would you know when is a good time to start looking at a product like this?
No one's going to ring the bell, per se. But I said when interest rates get back to what would be considered more normal and when the yield curve looks normal, where we're not at historical lows and where we're somewhere around the median of what rates have been for the last couple of decades, it's time to consider [annuities].

We won't necessarily do 100% at one time. One of the suggestions often made, and I think it makes sense, is you ladder into it. We'll do 10% or 20% of whatever the total allocation we're planning on during a period of a couple of years.

And how about other annuity products and in particular the fixed deferred annuity or longevity insurance? What's your take on that type of product?
I think the longevity insurance is a brilliant idea, and assuming it's reasonably priced, will probably be the single most important vehicle. You'll get a lot of bang for your buck if you live long enough to see a payout, and it provides a great deal of flexibility in the design of the balance of the portfolio.

And from the behavioral standpoint it's very powerful. To tell someone to take 20% of their portfolio and annuitize it is difficult. Individuals are reluctant; they just don't want to do that.

But to tell someone who's, say, 50 years old or maybe even 60 that they can take a relatively small amount of dollars now and at 80 the deferred annuity will start paying them what seems like a huge amount every month the rest of their life--it sounds like an extraordinarily good deal. Individuals are not good discounters of future values so they're not discounting the fact that the big number 30 years from now it really isn't such a big number. But it feels big so it makes the investment much more palatable.

It also helps from a planning standpoint in doing a capital-needs analysis. If you know you have a good solid income stream kicking in at age 80, it's often possible to significantly increase the probability of success of a plan.

Now, it's not a free lunch, and you're clearly giving up a certain element of corpus. So if you die, you might be leaving less. But our goal is to increase the probability of our clients achieving their goals.

So, would you recommend that someone add inflation protection to whatever annuity they're considering?
Well, the biggest weakness of immediate annuities is the fact that they're generally subject to inflation erosion. So to the extent you can find something like that fairly priced, absolutely.

But you'll pay a lot more for it I would guess.
Right. There's just not that much out there now that provides that.

And then in terms of gauging the creditworthiness of the insurer, the viability of the insurer, do you have any ...
[laughter] I'm only laughing because that's what keeps me up awake at night.

So what are your tips for someone getting their arms around that question?
The only advice I can give now is don't look at just payments. Start only with the very, very highest credit-rated companies today. Unfortunately that's no guarantee 20 or 30 years from now that even the strongest today will still be around, but at least it's a start. And then depending how much you're putting in, don't put it all with one company.

So, those are the two things that we unquestionably will be doing. We'll narrow it down to just a handful of, in effect, AAA companies, and then we will split between those companies.

So, would that occur as part of the laddering process that you would split among companies?
Even if we didn't ladder, and for that matter if we do ladder, let's suppose we put 15% in year one, we might put 5% in three different companies in year one and then 5% in three companies in year two.

I also wanted to touch on your bucket approach. You're one of the innovators in that area, and it seems like it's really taken off. Can you discuss the bucket system and why you think it makes so much sense for investors when constructing portfolios?
The one big difference between the day someone's working and the day they retire is that instead of adding to their nest egg, that individual will be taking money out of their nest egg.

When you're taking money out, volatility becomes an extraordinarily significant factor. It's kind of like the opposite of dollar-cost averaging, the worst of all worlds. You may be taking a lot out when you don't want to, or very little when you should be taking more.

So, it's what's called volatility drain. The reason people get in trouble is if they live at the wrong time. If the year they retire happens when the market crashes, they may dip into principal so much they can never recover.

And that's true even if during the next 20 years they get exactly the same return as their neighbor who retired a year later when the market went up. So, there's just a huge element of luck, in effect. So, the question that we face is how can we manage that risk? And the solution that I developed back in the early 1980s was a fairly simple idea. I wish I'd called it buckets at the time, but we called it the cash-flow reserve.

We believe that no one should invest money--stocks or bonds--unless they have a five-year window to decide when to sell. And five years isn't magic, but it's roughly an economic cycle. The point is that if you've got a five-year warning, you're never likely to take a very big loss. Whereas if the market just crashed and someone came to me and had a $1 million and said, "I need $200,000," I'm hoping they're telling me they need it five years from now, not next week. If they need it next week, they're going to take the loss and they'll never recover it. If we can wait five years, the likelihood of taking a big loss is, at least historically, very slim.

So, that was the beginning of the thought process. We called it a five-year plan, which simply means that if someone came to us and they've got a pot of money, we'll ask what are their expenses in the next five years?

"I've got to pay for the kids' college," they'd say, or for a wedding. We'll say fine. We're going to carve that out and put that in cash, in certificates of deposit, or short-term bonds. These are not your "investment dollars." The problem we had was someone who came in with $1 million and said, "I need 5%, I need $50,000 a year." And carving out five years' worth of cash flow was problematic because that's a pretty big opportunity gone if that's sitting in cash.

So, in playing with different possibilities, we looked at one year, two years, three years, four years, five years for the cash-flow reserve. Two years seemed to be the most effective reserve for cash flow for your grocery money.

So for someone with a $1 million portfolio who needs $50,000 a year, we carve out 10% for cash-flow reserves. That means 90% of someone's nest egg is invested in a total-return portfolio that we can manage for tax efficiency and expense efficiency, rebalance, and not have to worry about constantly dipping in and out of it. So that becomes a total-return portfolio. Everything gets reinvested. The cash-flow reserve this $100,000, this 10% gets invested somewhere between money markets, maybe CDs, or short-term bond funds, depending on what the expectations are.

Generally, we'll leave the amount a client may need in the first six months or so in money market funds. We might go into a high-quality short-term bond fund or six-month to one-year CDs on some of the balance. But basically these are very liquid, very high-quality investments.

We'll set that up literally to pay to our clients a check once a month to their local bank account so it meets with what [my wife and partner] Deena refers to as the "paycheck syndrome." People are used to getting a paycheck. So now, they get a paycheck. At least once a quarter we review the allocations, and at some point, we need to rebalance. We'll look over the cash flow and say, "Gee, it's low. While we are doing this, let's fill it back up again."

Along the way, as part of the management of the investment portfolio, we almost always have the opportunity to occasionally fill that cash-flow bucket back up. But imagine if we went through a two-year period that everything was down in the investment portfolio. Interest rates went through the roof, stocks were down, and the client used up the two years' cash reserves. What are we going to do for an encore?

Just in case of such a situation, we have what we call our second-tier emergency reserve in the investment portfolio. We have at least another three years' worth of living expenses that we could liquidate without having to take any or certainly much of a loss.

All of our portfolios have a fixed-income allocation; the maximum equity weighting today would be 80%. Most of the portfolios have 30% or 40% in fixed income. Because we ladder our fixed-income position, we have a reasonably big chunk down at the high-quality short end of the duration exposure. Tapping that fixed-income position might throw the portfolio out of balance, but our thought process is that the second-tier emergency reserve, combined with the cash-flow reserve, can take us through a four- or five-year economic cycle. Again, it's never happened.

Right, and you saw it stress tested.
Having this cash-flow reserve system is probably most important from a behavioral standpoint. When the market is tanking and people are jumping out the window, our clients know where their grocery money is coming from. It's not like they're looking at their nest egg and saying "Oh my God! I lost it all! I'm going to have to sell to buy groceries." So there is a phenomenal comfort factor in knowing that you can pay your bills from your money market reserve account and you can afford to wait for the world to get more rational.

Today it's funny, but it wasn't at the time. Back in the Black Monday 1987 crash, most of my clients at that time were what we called "CD Investors"--very conservative retirees who have been rolling over jumbo CDs. I was really scared to death, I had everyone in the office in at 7:00 in the morning waiting for the phone to ring and it didn't. Now, I was really scared because I figured our clients were either dead or on their way to the hospital.

So we got on the phone at 9:00 a.m. and the first woman I called, a retired widow from Miami Beach, said, "Well, what do you want?" I said, "Well, you might have noticed that the market was a little rocky the last day or so." And I swear, she said to me "I know. Five years, five years, five years." She knew where her grocery money was coming from. The point is, our clients were able to step back and think about what they really owned, and they really weren't worried that all those companies that they owned were going bankrupt.

I sat down with another client, a retired surgeon, a classic curmudgeon, following the tech crash. We went through the capital-needs analysis, and I said, "Look, this is not exactly what we had hoped, but you're still in reasonably good shape."

And he said, "Let me get this straight, you're telling me I don't have to be happy, but I don't have to worry?" To me, that was like "Wow! Bingo!"

We can't make people happy when things are crashing, but we can, at least get them to the point where they're not scared. Having that cash enables investors to step back and look more realistically at the future. So that's what we found the simple bucket does.

It does a lot of other things. It means we can manage the portfolio much more tax efficiently because it means we have control over it, as opposed to the randomness of the market having control.

So now you're hearing about advisors who have many buckets, not just a couple. What's your take on that approach? It strikes me that there would be a lot of moving around among buckets, not just filling up the cash bucket. Each bucket would have to become progressively more conservative, which would seem to be almost a full-time job for someone.
In an ongoing operation it seems extraordinarily inefficient and problematic, and from a behavioral standpoint, I think it may be a major issue. I have seen four, five, six buckets; it may work day one, but I'm not sure what you do for an encore.

In other words, when that first bucket gets used up, and the next bucket, depending on the time frame, maybe hasn't recovered. I just don't know how you go about managing the transactions, taxes, and expenses. How do you rebalance between all these buckets? I'm trying to get some of my academic friends to do some research with me.

[Stanford finance professor and Nobel Prize winner] Bill Sharpe has what he refers to as his lock-box approach, which is the ultimate bucket approach. I did a talk at a meeting a couple of years ago--it was largely academics--and he was one of the speakers also. He was criticizing practitioners like ourselves for how inefficiently we manage money and invest.

Really the basic theme, and I've heard this from a lot of academics, is the amount someone takes out of a portfolio ought to vary as a function of what happened in the market that year.

Professor Sharpe suggested that if you're retired and let's say you figure you've got 20 years left, you take the money and you break it into 20 pieces and you invest each piece separately in a lock box with those further out being more aggressive. Each year, you open that lock box and whatever's in there, that's what you spend.

I have little doubt that is really the efficient way to do it; Lord knows he's a brilliant person. But it doesn't work with real people. "Hey, Mom, this year let's go take a cruise. Next year, we're eating cat food." That's just not the way most people want to live.

And the other problem, maybe not quite so dramatic, is that a lot of the strategies that I've seen are based on making what they refer to as modest adjustments on a yearly basis.

The problem I have with this occasional adjustment is that for most individuals, the quality of their life is at the margin. What I mean by that is that if someone is spending $50,000 a year and you say, "Well you only need to reduce your spending by $5,000, that's just 10%." That's not a very big adjustment. But it's that $5,000 that determines do they go out to dinner, do they go to the movies, and do they take the kids to Disney World.

So to tell someone, "Ah, it's not a big deal, just this year you don't go out to dinner, you don't go to Disney World, you don't go to the movies," that's a huge impact on the quality of someone's daily life.

Our approach is designed for a fixed real return. Now, we review that on an annual basis. If someone was not spending as much, we may adjust it. But basically if someone needs $50,000 a year, our assumption is they're going to want that every year growing by inflation.

In reality I'm sure you find that people's spending patterns in retirement are not static, however, and so as they get older, they probably spend less, assuming they don't have big health-care costs. Is that something that you have observed?
No. While statistics demonstrate that that's the case, I think there are two problems with those statistics. One is that they're yesterday's statistics, and two, the fact that people are spending less doesn't necessarily mean they wanted to spend less. It may very well mean that they had to spend less.

The traditional concept is that as people get older, they get sicker, and therefore they spend less. But many of today's retirees are likely to stay healthy until they die--particularly the kind of people who can afford to come to me or who can afford to spend the time and energy to read Morningstar reports. They've have had better health care and better nutrition all their lives.

A couple of years ago, Deena and I went on a cruise, a very nice, very expensive cruise. There were lots of people in their 70s and 80s, and I'm sure people in their 90s. Some with walkers and some with oxygen tanks. But the point is they were still having a good time and still spending money.

So I think the statistics that the academics look at don't reflect the dramatic changes. Not only are people living longer, they're living much healthier. I think it's extraordinarily dangerous to assume that they will need less.

The idea of people getting older and just sitting out on the porch in rocking chairs, I think that's yesterday's story.

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