Graham Westmacott CFA

Portfolio Manager

Susan Daley CFA

Associate Portfolio Manager
  • T519.880.0888
  • 1.877.517.0888
  • F519.880.9997
  • The Marsland Centre
  • 20 Erb St. W,
    Suite 506
  • Waterloo, Ontario N2L 1T2

More Juice from the Lemon

November 26, 2013 - 0 comments

“Happy families are all alike; every unhappy family is unhappy in its own way”. Retirement portfolios are like Tolstoy’s families – there are a wide range of afflictions that can make them unhappy.

The perennial retirement question is how much lifelong income can I get from my accumulated savings?

The answer depends on a number of factors, and investment return is the one that garners most attention. After all, a higher investment return implies a larger withdrawal. However, with higher returns comes higher risks. Pre-retirement, risk is identified with market volatility. After retirement other risks materialize:

  • the risk of outliving your money (longevity risk)
  • the risk of fluctuating income because of changes in portfolio values (expenditure risk)

Under these circumstances, designing the best portfolio becomes both more complex and more personal.  

More complex because reducing one risk increases another. For example, holding an equity dominated portfolio may, on average, increase the size of the portfolio. However equity dominated portfolios that are subject to withdrawals are more at risk of either doing very well, and leaving money to your heirs that you could have spent, or doing very badly and running out of money.

More personal because other sources of income, taxes, spousal income etc. all play a role in shaping the retirement portfolio.  In other words, you can’t buy a retirement portfolio off the shelf and expect it to perform well.

A recent study by Morningstar assessed the main strategies for improving the income from retirement portfolios and concluded that they had the potential to boost retirement income by 22.6%.  This is a significant improvement and, crucially, the strategies can be pursued by all retirees. If so, this begs the interesting question, where does this additional income come from?

Let’s look at each of Morningstar’s suggestions:

Asset Location and Withdrawal Sourcing

This is all about tax efficiency:  about how to allocate investments within different savings vehicles (TFSAs, RRSPs, corporate, and personal investment accounts) prior to retirement and the sequence of withdrawals in retirement. In addition, international tax treaties can impact the dividend returns from foreign investments and judicious tax loss selling can reduce the impact of taxable gains.

Those who do well reducing, or at least deferring, the portion of investments that go to the tax authorities gain an estimated 3.2% additional income.

Annuity Allocations

The annuity concept is simple: a lump sum is paid to an insurance company who guarantees a fixed payment every month until death. Annuities are unique in providing a stream of income no matter how long the annuitant lives, so there is no risk of running out of money.  One of the trade-offs is that there is no benefit to the estate on death. Buying an annuity and dying shortly afterwards is a bad outcome for your heirs. Under these circumstances, some of the income that would have been paid to the deceased annuitant is paid to other annuitant holders.  Thus annuitants that live longer than expected by the insurance company benefit at the expense of those who suffer a premature death.

The Morningstar study suggests that including an annuity raises, on average, portfolio income by 1.4%.

Dynamic Withdrawal Strategies

Ideally, most retirees would like a constant monthly income. However portfolios last longer if the monthly income is a constant percentage of the portfolio value (4% is a common rule of thumb). A constant percentage leads to lower dollar withdrawal when portfolio values decline, which helps avoid a “death spiral” when there is a sequence of poor market returns.

More sophisticated spending rules take into account both the portfolio value and projected mortality and reduce the likelihood of either spending too little, and leaving a large inheritance, or spending too much, and outliving your money.

Dynamic withdrawal strategies improve retirement income by decreasing both the risk of over consumption by the retiree and leaving unconsumed assets as an inheritance. For the base scenario Morningstar assumed a withdrawal of 4% of the initial portfolio value. Compared to this base scenario, the dynamic spending rule added an additional 9.9% of retirement income.

Total Wealth Allocation

Prior to retirement the size of the accumulated next egg at retirement is dictated by investment returns and savings rates. Savings usually come from a portion of employment income, which is subject to its own volatility and uncertainty. Careers change, promotions come and go, and income may be steady or tied to some volatile factor (e.g. sales commissions). Taking into account these risks to savings rates can improve the portfolio asset allocation and accumulated values. For example, a tenured university professor has a stable income and savings rate which would allow a greater allocation to risky securities than, say, a stock analyst. In summary, the professor has bond like human capital while the analyst has more equity like human capital.

Modifying the asset allocation to take into account the volatility of the human capital can boost the size of the accumulated portfolio and the amount of income that can be withdrawn. Morningstar estimates this to be an additional 6.4% of retirement income.

Liability Relative Optimization

Portfolio design is usually focussed on assembling the best combination of assets to achieve an expected return at minimal risk. The requirement to fund future expenditure is ignored. Taking future expenditure into consideration changes the portfolio asset allocation. For example, pension plans that are concerned about matching long term pension liabilities will continue to purchase long term bonds even when their total return to the portfolio may be small.

Morningstar estimates taking future payments, or liabilities, into account can improve retirement income by 1.6%.

Putting it All Together

The total contributions results in the potential of a 22.6% increase in retirement income. Morningstar estimate that this additional income is equivalent to generating an additional portfolio return of 1.59% annually. Other commentators, such as Vanguard, have called this additional return “Advisor Alpha” in recognition of the value that competent advisors can add to their client’s retirement.   Of course, these figures must be regarded as estimates and will certainly vary from individual to individual.

One of the Morningstar authors, Paul Kaplan, was a guest speaker at a recent PWL Investment Meeting and we expect to pursue these studies in a Canadian context in the coming months. 



 “Alpha, Beta, and Now…Gamma”, David Blanchett and Paul Kaplan, Morningstar, August 28, 2013   Alpha, Beta and now Gamma – Morningstar

By: Graham Westmacott with 0 comments.
Blog post currently doesn't have any comments.

 Security code