Where to Go for Portfolio Income in Retirement

On this episode of The Long View, Robert Powell discusses generating income in retirement, looking at a retirement-income plan much the same way a pension plan looks at how it meets its obligations, bond ladders, and more.

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

Ptak: Focusing specifically on retirees, what additional assets belong in their portfolios, in your opinion?

Powell: I think folks need to think about how they’ll generate income in retirement, ultimately, and what kind of risk they want associated with that income. I’m always a fan of suggesting that one maybe look at their retirement income plan much the same way a pension plan looks at how it meets its obligation to its pensioners, which is, we need to have a certain amount of assets to fund the liabilities that we have, and there can be no uncertainty that we meet those liabilities. So, I would say folks probably need to think about what assets do I need to fund my desired lifestyle and the lifestyle that can’t be put at risk. That might be for some essential expenses; for others, it might be essential and discretionary. But whatever it is that there’s an asset there to cover that expected expense. For some, that may mean bonds or zeros, or perhaps it might mean single-premium immediate annuities. For others, it might mean a bond ladder. But whatever it is, I think, people need to think about adding the assets that will fund their necessary expenses at a minimum.

Ptak: Sometimes when the markets fall, we see investors overcorrect in one way or another. After the great financial crisis, for example, we saw a stampede into bonds, even though yields were very low and equities were cheap. Are you seeing anything you would characterize as an overcorrection today?

Powell: At least on the retiree side, I haven’t seen that kind of overreaction. What I have seen though is, at least for folks who are saving for retirement, this notion of higher yields in the bond market and that long last, maybe the desire to go out a little bit longer on the yield curve in order to capture some of the higher yields. I wouldn’t necessarily call it an overreaction. I think it’s more a reaction to a decade-plus of a zero interest-rate policy period in which people stayed very short with their money because there were no other places to go except maybe the stock market. So, I have seen people maybe get a little bit more aggressive in terms of going out on the yield curve and taking advantage of higher yields.

It’s an interesting discussion though, because I think sometimes there are—you have written about this, others have written about it—this notion of nominal and real returns. So, while folks might be getting a higher nominal yield with interest rates as high as they are, they’re still getting a negative return at least on their interest income. So, I think people also need to think about just because yields are high, it doesn’t necessarily mean that it’s better. It’s certainly better than 0% for sure, but I think people need to be conscious of the fact that their real return is still negative.

Benz: Right. That’s such a good point. And I know inflation has been top of mind for a lot of retirees, a lot of people in general. It’s declined a little bit, but it’s still really quite high relative to the previous few decades. So, thinking about retirees specifically, how should they protect their plans in case inflation stays elevated? Maybe you can talk about at the portfolio level and also at the total-plan level, what people should be thinking about who are in retirement or about to retire?

Powell: As I mentioned, I’m a fan of bond ladders or income ladders or asset/liability-matching for people who are building retirement income plan, or the bucketing approaches you’ve written about—people describe it in different ways. For many who are worried about inflation, it might be a case of where you shorten the first bucket, the safety bucket per se, and instead of maybe it being three or five years, maybe it’s three to one year so that you’re putting less of your money in instruments that would suffer the most from at least a higher rate of inflation in the short term. And should inflation remain elevated, that second bucket where you might have a mix of stocks and bonds presumably would be used to hedge against higher inflation rates. And then, maybe keep that bucket just as short as well instead of, say, maybe a five- to 10-year bucket for that middle bucket, maybe that is five to seven years. And, then, your third bucket, the bucket that’s really designed for long-term expenses and the bucket that’s really designed to hedge against inflation, maybe instead of it being set at 10 years, maybe it’s now set at seven. So, I would probably just shorten the bands on my buckets as I was thinking about what amount or percentage of my assets need to be in these various buckets in order to protect against both in the short-term a higher range of inflation, but also a persistently higher range of inflation.

The other is, when I think about inflation with it, obviously people think about the loss of purchasing power and what that could mean, a dollar being worth $0.50 over the next 30 years. I also think people need to think about retirement. At least according to the research I’ve read, and perhaps that you’ve read as well, Christine, is that spending, real spending, declines in retirement. So, David Blanchett, when he was at Morningstar had that famous study that looked at the smile. Michael Hurd at the RAND Corporation recently published a paper that echoed the same. J.P. Morgan, also with real clients looking at their spending patterns over the course of retirement, consistently show that spending declines over the course of retirement from the go-go years to the slow-go, and then may or may not increase in the no-go years.

I think people also need to not put inflation in the context of what their actual spending will be in retirement. So, while inflation may be high today, it’s likely, perhaps I’m willing to bet, that it will return to maybe its 3% average over the course of the next three decades or so. And be mindful of the fact that as you’re entering retirement, it won’t be necessarily a 3% inflation-adjusted expenses that you’ll face in retirement. It might be 1% or 2% real. So, again, it’s like thinking about, well, I can read the headlines, but I also need to think about how this applies to my own plan and the plans of many other retirees. It’s one thing to think that inflation is high, and you’ll forever have a loss of purchasing power, but it’s a whole another thing to think about what will actually happen in reality.

Ptak: You referenced bond ladders earlier. But is there a risk to people building portfolios of individual bonds that smaller investors might have trouble finding a way to be adequately diversified, for instance?

Powell: I often start my retirement speeches by talking about how complicated it can be, how confusing it can be, how contrary it can be. I’m often reminded of the famous example I often use is that you have folks who might say that stocks are great for the long run. And then, on the other hand, you might have someone like Zvi Bodie saying stocks are always risky. So, how do you navigate a world in which you’re getting two different opinions from two different esteemed subject-matter experts?

For anyone to do this on their own, I think it can be done, but I think it would require becoming a student of the subject and taking full advantage of all the tools that might be out there at Morningstar or other places in order to build a bond ladder, or to be knowledgeable enough. When I began writing about retirement exclusively in 2003, reverse mortgages weren’t a thing. Secure Act 1 and 2 were not a thing. So, for people who have to understand all the products, regulations, strategies, pros and cons of strategies, I think it becomes really difficult for someone to do it on their own.

If nothing else, I think having someone go to an advisor to act as a sounding board would be helpful. I’ll give you an example. Yesterday I got an email from a family member whose advisor had recommended to them that they switch out of an investment they had into an annuity. And the only contacts I had was a product sheet on the annuity. I had nothing from the advisor to say why we’re doing it, what are the pros and cons of doing this, how does it fit into the family member’s portfolio. And mind you, this is a person with an advisor seeking out a sounding board. Imagine a person without an advisor trying to figure out whether to buy this or that product and how it fits into their plan, I think is a tall order. It can be done. Like I said, I think you need to become a student of the subject and become a student of the subject perhaps in the same way that you become a student of your job to actually get a good feel for whether something or not makes sense for you—what investment to add, what strategy to consider and how to go about it?