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Falk: Immunize Your Retirement Portfolio Before Optimizing

Focus Consulting's Michael Falk suggests retirees pare down their fixed liabilities in their total portfolio so that they can make their discretionary spending much more manageable.

John Rekenthaler: I'm John Rekenthaler at Morningstar, and I am with Michael Falk, a partner of Focus Consulting Group and partner and strategist at Mauka Capital. Michael, thanks for joining us at the Morningstar Investment Conference.

Michael Falk: It's pleasure John. Thank you.

Rekenthaler: You [talked] about something a little different than we normally get at Morningstar Investment Conference.

Falk: I thought we'd have a fun day and a half talking about assets and portfolio management, and when it comes specifically to retirement planning, people are going to be much better off and more successful if they manage their liabilities not their assets.

Rekenthaler: So we have asset managers here, but you are talking about liability management?

Falk: Yes. Specifically, it enables the asset management in a way. If you think about liability management, lower debt as an example, lower fixed bills or expenses every month as compared with your total spending, Social Security, pensions maybe a laddered bond portfolio can cover that with virtually zero risk. Those fixed expenses.

As those are a smaller portion of your total spending that means everything else is more discretionary, which means that if you do take additional risk within your asset management and the market takes a nasty spill, it doesn't affect your lifestyle. And that's the beauty of this type of strategy, which I refer to as you should immunize before you even try to optimize.

Rekenthaler: We at Morningstar, including me, spend a lot of time writing about asset management strategies during retirement. Should you withdraw at a 4% rate or should it be 3% now? The numbers change, and we have these discussions going. Should you have more equities or less equities? And what you are saying is that's all fine in a way, but you could likely make this moot if you control your liabilities entering retirement. So you don't have to worry so much about generating that much income.

Falk: That’s absolutely correct. Whenever we make assumptions, what we know is that we raise some potential risk because it's uncertainty, and we don't know what's going to happen. If you would start withdrawing 4% every year and your spending rises maybe because of health-care needs, or the market goes down, that could really disable your overall asset picture and the future of your retirement planning. It's not that 4% is wrong, but if we start from a base of immunizing or planning for fixed expenses to be covered and then everything above that is discretionary expenses, well then risk can happen, and it doesn't disrupt.

So what I advocate is maybe start little bit more simply, maybe start with looking at how the total spending plan splits into both the budget for fixed expenses and in the balance of the spending plan for all those discretionary things that you love to do. Then once you get to a point of covering your fixed expenses, and if you go into retirement with little debt--the house is paid off and maybe you go down to one car that is paid for--you make that so much more manageable. Now you can roll with the markets punches so much more easily. It also means that there is no preset amount of equities that you should or shouldn't own. It also means there is not a preset amount of liquidation 3%, 4% that you should take every month.


Rekenthaler: Making things so simple.

Falk: Well you know what the nice thing about simple is you can do it. The difference with complicated versus simple aside from people who can understand both is the average person--who we're talking about, trying to serve the average person here--the average person can execute simple. They cannot execute complicated; they'll break it. And if they break it, then they get harmed.

Rekenthaler: A positive outcome from an investor's point of view of tight liability management means you don't need to have as many assets or as a large a pool to cover because as, you say, your budget plus spending needs are smaller when the liabilities are smaller. You also talked about possibly shrinking the time horizon in investment strategies during retirement, as well, which also helps to so that people don’t have to have these ginormous asset numbers that you see, this many x millions you should save and so forth, that can be fairly terrifying as well as unrealistic.

Falk: There is nothing wrong with having $2 million or $3 million in a pile of cash or more when you retire. But you've got to understand people have to work to get there. So you've got to do a trade-off from current-day life to future-retirement life. And that trade-off is a very difficult thing for people to decide upon, and to execute. Again [keep it] simple. If you think instead of working to age 70--some people might be offended by that. But trust me when I say that's likely going to happen for all people in the future. I won't get into the details.

Buying what's known as an advanced life-delayed annuity, a concept that was put forth by Moshe Milevsky many years ago--you buy an annuity that starts making payments at your expected mortality, let's say 83 as an example because that’s a common average mortality for unisex in the actuarial tables today. That means you only have to have enough from the savings to generate income for 13 years. From that, it's an oversimplified, but simplified, perspective.

So 13 years. When most people say if you want to be safe, you need to start saving and think about 25- to 30-year horizon. It fundamentally alters the amount of savings that are needed. Now we have to be careful because we're not going to tell people to save less because this is your plan. We just let people know that this is potentially your plan. If you save more, what that does is it gives you more control. It gives you more control on whether you want to retire early, or do you want to work longer. It gives you more control in terms of what you'll be able to do during retirement.

So there is no right answer here. That's where sometimes the overcomplicated and the software comes into play. It seems to indicate there's a right answer. There are many answers. What is that you want? What do you want to get out of retirement, and what trade-offs are you willing to make.

Rekenthaler: Thank you Michael.

Falk: Thank you, John.

Rekenthaler: That was Michael Falk talking about liability management. Thank you.