Prior to the financial crisis of 2008, retirees had fairly straightforward asset-allocation decisions to consider. Financial advisors commonly recommended that one’s portfolio should shift to a 60/40 stock-to-bond ratio upon retirement. The rationale for such a recommendation was to dampen market risk by reducing stock exposure since growth was less of a priority in retirement. A heavier bond allocation would provide stability and the income needed to support retirement living expenses. Portfolio construction for retirees now requires a different approach given that interest rates have dropped dramatically and have remained at historic lows since the financial crisis.
The yield generated from a typical bond portfolio, as measured by the Barclays US Aggregate Bond Index, has declined from 4.5%, just before the financial crisis, to 2.7%, where it remains today. This drop represents a 40% decrease in the amount of income generated from the bond portion of a portfolio. The obvious conclusion is retirees now need fewer bonds and more stocks. The challenging part for retirees is determining the correct percentage of stocks and, perhaps more importantly, what stocks to own.
To achieve the appropriate stock allocation, retirees should first determine their known short-term expenses (1-2 years) and intermediate-term expenses (3-5 years). Next, make sure that these expenses (or “liabilities”) are matched with your income sources, including cash, bonds, and annual portfolio income. Cash should be used to cover your short-term expenses, while bonds should be used for intermediate-term expenses. This approach, called asset/liability matching, achieves a number of very important objectives:
• Establishes a stock/bond asset allocation and the reasoning behind it.
• Reduces emotional investing, knowing you have at least 5 years of expenses covered so you can patiently wait out the inevitable market turbulence.
• Eliminates poor market timing by avoiding the need to sell high-quality stocks at depressed values to fund cash flow requirements.
Once the proper asset allocation is determined, the next step is deciding how to invest the stock portion. Fortunately, in the post-financial-crisis era, many companies have a renewed focus on paying and growing dividends, so much so that the S&P 500, until recently, had a higher dividend yield than the 10-year Treasury Bond. With a 25- to 30-year retirement time horizon, inflation is a bigger risk for retirees than short-term market volatility. With this in mind, it is important to invest in high-quality companies with sustainable dividends, which can grow annually to keep pace with or exceed the rate of inflation. While the stock market will fluctuate, a well-diversified portfolio of dividend-growing stocks will provide an annual raise for retirees even through periods of flat or negative market returns. The power of growing dividends from stocks versus the guaranteed flat level of income from bonds is well illustrated in the chart below, which compares the stock and bond income for Johnson and Johnson.
The investment selection process needs to be carefully considered because two companies in similar industries with equal dividend yields could have wide discrepancies in the sustainability or coverage ratio of their dividends. Proper research is required to ensure, among other things, that the dividend is sufficiently covered by free cash flow and the company’s balance sheet is solid and allows for flexibility during challenging economic conditions.
In today’s market, determining the right asset allocation and investment selection is no longer a “one-size fits all” for retirees. It is important to work with a financial advisor who can integrate knowledge of your personal circumstances with a deep understanding of the current markets.