4 Retirement Questions: How to Find Appropriate Asset Allocation

On this episode of The Long View, Bill Bernstein, neurologist turned investment advisor and author, joins Morningstar’s Christine Benz and Jeff Ptak for the third time to discuss retirement, risk, return, inflation, and more.

Here are a few excerpts from Bernstein’s conversation:

Asset Allocation in Retirement

Christine Benz: I want to switch over to discuss people who are later in their lives who are thinking about retirement or maybe already in retirement and talk about the questions they should ask themselves to arrive at an appropriate asset allocation. These are presumably more seasoned investors who know themselves a little better, but assuming they want to try to construct a sensible in-retirement portfolio, what’s the starting point? What are the questions they should ask themselves?

Bill Bernstein: Basically, the person who is approaching retirement has to ask themselves four questions. Number one, what is their burn rate? Is it 1% or 2% or is it 5% or 6%? And the higher your burn rate, the more conservative you should be and the more you should favor annuitizing products, and we’ll probably get to that in a minute. The second thing, of course, is how old are you? Someone who is a FIRE person—financial independence, retire early—and wants to retire at age 40, better have a fairly aggressive allocation with a very low burn rate. The third thing, of course, is their risk tolerance. And then, the fourth thing, which relates to the risk tolerance, is how they balance off safety versus a bequest. For example, do you want to endow a wing at the hospital? Well, then you should invest very aggressively, and you better have a fairly low burn rate. On the other hand, if you’re primarily concerned about your safety, then you want to have a more conservative asset allocation. So, there’s a whole lot of things that are there in the mix and there’s really no one size fits all. You have to answer those four questions and then figure out where you are on that spectrum.

Basic Fixed Annuities

Jeff Ptak: Many academic researchers are big on annuities as a component of the retirement plan, particularly very basic fixed annuities, which provide a lifetime stream of income. You’re not a fan. Why is that?

Bernstein: Well, for at least two reasons. Number one is because you are taking a massive inflation risk with a fixed annuity, which has a nominal payout. The reason why you buy an annuity is for longevity insurance, but guess what? If 30 years of inflation turns the U.S. dollar into funny money, even that longevity protection goes away. So, that’s number one. You’re taking a massive amount of inflation risk, particularly a large amount of inflation risk with a deferred annuity because there you’re not getting paid for many, many years. The payout may look nice and fat and spectacular 20 years before it pays off, but when the payout finally comes, you may be sorely disappointed by its purchasing power. So, that’s number one.

Number two is the credit risk that you’re taking. These are all commercial products and people are very fond of pointing out, yes, these products have state guarantees, but of course, they’re funded by the insurance industry. There is nothing magic about a state guarantee. Most states have fairly low caps on the amount that is protected. And then, finally, even those guarantees can fail. And if you don’t think that that can happen, you should go Google “Executive Life Insurance.” And that failed very spectacularly. And the reason why it failed was because the state insurance commissioner decided to shaft the beneficiaries and then very shortly thereafter wound up at a private equity firm, and the kind of private equity firm that was involved in Executive Life’s flameout.

Treasury Inflation-Protected Securities

Benz: You favor a laddered portfolio of TIPS bonds—Treasury Inflation-Protected Securities—instead for that sort of guaranteed income that is in fact inflation protected. So, how should a retiree decide how much to put into such bonds?

Bernstein: As I explained before, it really depends upon what their burn rate is. If their burn rate is fairly low, they don’t need TIPS. Now my burn rate is low, but I still own them simply because I really like sleeping at night. On the other hand, if your burn rate is in excess of 4%, then I think that a ladder of TIPS, or at least a TIPS fund with a maturity that somewhat matches your financial horizon, your survival horizon, is also not a bad idea as well. So, really it depends upon what your burn rate is. A low burn rate, you don’t need TIPS; the higher your burn rate, the better an idea they become.

Ptak: Does the timing matter when someone builds a laddered TIPS portfolio? For example, TIPS had negative real yields just a few years ago, which seems pretty important to somebody that’s building a TIPS ladder. What do you think?

Bernstein: Yeah, it matters a lot. Just because you believe in market efficiency and the fact that you can’t predict interest rates doesn’t absolve you from the duty to estimate its expected return. So, about 18 months ago, the five-year TIPS was yielding almost minus 2%. It was minus 1.90%. It’s not a good idea to buy TIPS when yields are that low. You’re guaranteed to lose 2% of your spending power every single year. Is that market-timing? I guess I plead guilty to that. The nice thing about real rates and TIPS rates is that occasionally the Fed does have to do its job and take away the punch bowl. And when that happens, that’s a good time to buy TIPS. So, there’s still an attractive purchase right at this very moment. I think that the average yield through the yield curve on TIPS is about 1.6%. You could do a lot worse than that. This isn’t a bad time to buy them.