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Graham Westmacott CFA

Portfolio Manager

Susan Daley CFA

Associate Portfolio Manager
Contact
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  • 1.877.517.0888
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  • The Marsland Centre
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    Suite 506
  • Waterloo, Ontario N2L 1T2

Securing Income in Retirement

April 27, 2015 - 3 comments

Asset Liability Management (ALM) is a useful technique for focusing on what matters most to retirees- a secure source of income.

When advising clients who are heading for retirement we see a shift in perspective from a focus on capital appreciation to a focus on income generation and protection. Specifically, we work with clients to understand how much future income they wish to protect and for how long. Many see the ideal as protecting lifetime income, which is equivalent to buying an annuity. However annuities don’t buy much future income at current low interest rates and even if clients could afford to purchase them, many are reluctant to do so because it is an irreversible decision. However, rather than protect a lifetime income it is possible to protect income for a fixed period of time, say the next 10-15 years.

The tools we have developed do exactly that. Client have to make two decisions: how much income they want to protect and for how long.

How much income to protect is determined by understanding how much income is required from their investments, usually to supplement income from government and possibly other pensions.

How long to protect income is a matter of choice but typically in the range 10-15 years. Many retirees see the period immediately after retirement as the most crucial and when they are likely to be most active. The planning horizon can roll forward as a fixed period or change, depending on circumstances.

To see how this works in practice we illustrate with two couples: Alan & Brenda and Claire & David. The year is 2007 and both couples are age 65 and looking forward to their first year of retirement. Both have $1,000,000 of investment capital.

Alan & Brenda have a portfolio of 60% equities, 40% fixed income and they have been advised that the popular 4% withdrawal rule will allow them to withdraw 4% of their initial capital, indexed to inflation, without running out of money. Thus they expect $40,000 in the first year, rising with inflation. Their advisor had them complete a risk questionnaire that showed they were tolerant of the risk associated with the price fluctuations of a 60% equity portfolio.

Claire & David had a different advisor who listened to the importance they attached to income stability. They also wanted to withdraw $40,000 annually, indexed to inflation and wanted to make sure that this could be done for 15 years on a rolling basis.

Roll forward to Feb 2009 and Alan & Brenda’s portfolio is depicted in the chart below. Alan & Brenda have received their monthly payout but their portfolio has suffered badly from the financial crisis and is only worth $670,000, a 33% decline in just over two years. They are facing the real prospect of running out of money. To withdraw their 2009 pension of $42085 (indexed to inflation) requires withdrawing 6.3% of the portfolio. They consider some combination of giving themselves a pay cut or reducing their equity exposure to preserve their remaining capital. Getting a part-time job to provide additional income doesn’t seem an option in the prevailing economic climate.

Claire & David have also received the same monthly payout as Alan & Brenda and are also seeing their capital eroded, but to a much lesser extent (their portfolio is worth $838,000 a 16% decline).  The chart below shows Claire & David’s portfolio with Alan & Brenda’s as a dashed line for comparison. Claire & David are reassured that their pension is protected for the next 15 years and they can afford to take a long term view.

How did Claire & David protect themselves? The process is called Asset Liability Management (ALM) and is well established in the pension industry but underused for individual clients. The process can be summarised as follows:

  1. The lump sum required to generated 15 years of $40,000 annually, increasing with inflation, is calculated using 2007 interest rates. The result, which we will call the ALM allocation, is $520,000.
  2. The ALM allocation is used to purchase a series of bonds1 which, through their maturity and interest payments, pay $40,000 annually. Hence the acronym ALM: an investment asset is used to match a future income liability.
  3. The remaining $480,000 is used to purchase a long term Growth Portfolio. In this case we chose a globally diversified 60% equity, 40% bond allocation.
  4. The ALM portion provided all the income. Each year the ALM allocation is recalculated using current interest rates and taking into account the pension payout, investment returns and any changes in inflation. The ALM calculation also accounts for the possibility of Claire & David dying. Since this probability increases with age, all other things being equal, the ALM allocation declines in real terms.
  5. The portfolio is rebalanced every year between the ALM allocation and the Growth Portfolio so the ALM portion always offers sufficient income protection. As a consequence the overall bond allocation in the portfolio also varies.

At the start of 2007, using the ALM approach, meant that an appropriate asset allocation for Claire and David’s total portfolio was 73% bonds, 27%equities. It is easy, with hindsight, to see the wisdom of this choice and why it fared better in the 2008 recession.

However, Claire & David made their choice, not because they could forecast the pending market decline but because they wanted to protect their income in retirement. Had Claire & David been 30 years old and had no need for income they could have adopted the same portfolio as Andy & Brenda and would have been content to hold out for the market recovery. The key message here is that, for retirees, risk no longer means price volatility but income volatility. Designing a portfolio with the wrong objectives can lead to poor outcomes.

In our story, Alan & Brenda cut back on their income and cashed out most of their equity investments. If they had had the stomach to persevere then we know, again with hindsight, that their portfolio would have recovered. In the figure below we plot the recovery for both couple’s portfolios, assuming both portfolios continued to make annual inflation adjusted withdrawals of$40,000. By the end of 2014 both portfolios have similar value, but Claire & David’s is much less volatile and they made the journey knowing that their income was secure. 

If Andy & Brenda had had the stomach to hang on – what would they do now?  

In summary, the ALM approach provides a steady source of income when it is most important. There is no free lunch and the trade-off is more secure income for a lower possibility of high capital appreciation. The size of the required pension and the value and length of the income period determines the bond/equity allocation and the structure of the bond portfolio. We used a constant, inflation adjusted, spending but any spending pattern could be incorporated. In addition there is no need to worry about a “spending rule” such as the one used by Andy & Brenda: the spending is an integral part of the portfolio design.

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1In our example we only use Government of Canada bonds: using a wider mix of investment grade bonds would increase the yield and reduce the ALM allocation.

 

By: Graham Westmacott with 3 comments.
Comments
  13/11/2015 2:37:07 PM
Graham Westmacott
Harry, thanks for your comments. You are correct that with interest rates at historic lows, securing future income is expensive compared with the past. However, relying only on dividend stocks is not securing future income at all (the S&P/TSX Composite Dividend index is down 7.65% YTD). Our suggestion is that retirees who conclude that a base level of income needs to be secured (maybe, as in this example, for a limited time horizon) then this provides a process for doing so. In the study not all the income was met from the ALM allocation (yields varied from 4.12%-1.51% in the period); the balance is provided by the Growth Portfolio.

We have published a white paper, “The Design & Depletion of Retirement Portfolios”, which provides further details and is available on our website or by contacting us directly.
 
  11/11/2015 4:51:26 PM
Harry Beach
Very thought provoking piece........ But wouldn't using todays bond yields to generate the same $40K indexed to inflation require most all of Claire and David's capital?

It seems to me that in the present low rate environment there is nowhere to go for boomers but dividend stocks and their greater volatility.
 
  04/05/2015 8:27:57 PM
Tim Miller Dyck
Hello Graham,

It appears from the figures above that $520,000 in various Government of Canada bonds was yielding $40,000 annually in income. This is a 7.7% yearly return. Looking up the Government of Canada 10 year benchmark bond yields for 2007, yields were between 4.03% and 4.62%, depending on the month. I'm wondering how you got to 7.7?. Can you say more about how to generate $40,000 in annual income from just government bond investments in the example above? Thanks!
 



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