Christine Benz: Hi. I am Christine Benz from Morningstar.com, here at the Morningstar Investment Conference. One hotly debated topic here at the conference has been asset allocation, and in particular, asset allocation for retiree portfolios.
Here to share his insights is Frank Armstrong. Frank is the President and Founder of Investor Solutions. He is also the author of four books. Frank, thanks for joining us.
Frank Armstrong: My pleasure.
Benz: So, let's talk about retiree asset allocation. How retirees can think about transitioning their portfolios, what changes they should make for their asset allocation as they get close to retirement and needing to put their hands on their money?
Armstrong: Okay. First of all, I think, you want to be positioned in the appropriate retirement allocation sometime prior to that date, because you don't want to make the decision of whether I retire tomorrow based on what happened to the stock market yesterday.
Benz: So, you want to be gradually tipping more into conservative…
Armstrong: Tipping more and we use a glide-slope approach. I think younger people can properly invest for higher returns with a higher level of equities, but as you get closer, you want to be positioned to withstand the market's ups and downs, as you'd have a withdrawal strategy.
Benz: So, for your typical 65-year-old client, how would you be allocating the assets between stocks and bonds?
Armstrong: Well, let's just say, for example, that we agreed on a 4% withdrawal rate, which we think is sustainable over the long haul. Then we might further go on to say that, stock market returns are variable and they can be down for quite some time. So, you need to have the liquid reserves to withstand that.
So, I would recommend that they have 10 years of retirement income salted away in very short-term fixed income investments, so that if the market goes down, we can continue to write those checks for them. And if we use 4% as a withdrawal rate, four times 10 is 40%. The rest of it we can put to work for longer-term gains, to hedge inflation and grow the portfolio. And that would be equity. So that might include 50% of foreign, 50% domestic portfolio.
I would overweight it strongly to small and value firms, because there's an additional premium there that we can collect, without collecting any additional risk, that's the magic part. Also, real estate has been a great way to hedge inflation and grow the portfolio and there are foreign and domestic real estate funds available that you can get into.
So, that's a place to start the discussion with clients, and some of them may be more aggressive, some of them may be more conservative, but you've got to have enough liquid assets to withstand that down-market when it comes. I can't tell you when it's going to come. I know it certainly will, sometime in the next 30 years, while you're retired.
Benz: So, you have to have either an awful lot of wealth, or a very frugal lifestyle to be able to stash away 10 years worth of living expenses ...
Armstrong: Retirement is expensive. And most people underestimate what it's going to cost. In fact, we were talking earlier the average 401(k) rollover is gone in five years. Well, what do you do for next 30 years? I don't know. So, if you start undercapitalized, then your set of choices is very, very poor, and I'm certainly not in business to preside over the liquidation of my client's wealth. So, for every dollar of income you need during retirement, you need $25 of capital to support that. It's very capital intensive enterprise.
Benz: So, let's talk about some ways that one should tweak his or her asset allocation based on their own particular life factor. So certainly, someone who has other certain sources of income, such as a pension in addition to Social Security, might be able to have a little more in equities than someone who does not?
Armstrong: Well, I look at it from the standpoint of, you give me a pile of money, and you tell me how much I've got to generate. And I don't have to generate the part from Social Security or other retirement plans or your military retirement, I am only responsible for generating X number of dollars from X pile of money. And, that's how I tweak the asset allocation.
I don't think necessarily that you could use Social Security as a bond to offset for instance, because that would end up with my portion, my pile of money I'm administering, being much more highly volatile than I would be comfortable with.
Benz: Okay. So, what other swing factors, though, should people keep in mind when thinking about well should my equity allocation be higher or lower …
Armstrong: Well, first of all, I think, sleeping well at night is a legitimate financial objective. So, if you are more conservative, you might go to even 40% stocks and 60% bonds then you'll sleep better at night as the market goes up and down. If your rate of withdrawal is different than 4%, then obviously we got to tweak for that.
If you are really concerned about leaving a huge amount of income for your next generation, then maybe you can afford to be slightly more aggressive, but the more aggressive you are the higher the chance that you might run out of money. There is a sweet spot there, where we can maximize the probability that you'll be okay.
Benz: So I want to briefly touch on some of the ideas, some of the investment ideas that might show up in client portfolios that you think are terrible for retirement. So, we talked about annuities; you are not a fan of most annuities, if any, are there other categories where alarm bells go off when you see that in the client portfolio?
Armstrong: We talked about investing for dividend and over-reliance on fixed income to generate income, and the whole idea that you should just live on the dividends and not ever invade principal is entirely different from what we know about how markets work--where the best approach is a total return portfolio and what I would call a synthetic dividend ... where on an annual basis or a monthly basis you determine what portion of the portfolio you should get your required withdrawal from.
Benz: And that's interesting. I think your insights into that are interesting and that you look to some of those categories that have performed exceptionally well even when they are very volatile categories that's where you look for that.
Armstrong: In a good year or if an asset class has really outperformed, we want to go back towards our original asset allocation, take some of those earnings off the table to reduce to maybe back to our target risk, and reduce the portfolio. If you just let it sit static it would grow like topsy, way out of control.
So, we are always looking to move back towards the asset allocation we set as a target. In good years, we'd probably reduce the stock side, in bad years we'd reduce the bond side. What that gives us in a bad year -- we don't have to liquidate those volatile assets, which would be an ever-descending spiral, which would make us all very uncomfortable.
Benz: Well, Frank thanks so much for sharing your insights. We really appreciate it.
Armstrong: My pleasure. Thank you.
Benz: Thanks for watching. I'm Christine Benz from Morningstar.com.