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Investing During Retirement - Part II
A Comprehensive Approach
Part I

by Frank Armstrong
President, Investor Solutions, Inc.
www.fee-only-advisor.com

Constructing the Investment Policy

Every step of the investment policy must support the retiree’s objectives. The ideal policy will support the required withdrawal rate while maximizing the probability of success.

The first problem that faces the retiree is that “guaranteed” investment products are unlikely to provide sufficient total return to meet his reasonable needs. Meanwhile, equities are far too volatile to provide a reliable income stream. A compromise must be reached. A combination of stocks and bonds will probably best meet the needs.

Because at least part of the portfolio will be volatile, the question of risk management moves to the forefront.  Our first step is to construct a “two bucket” portfolio.

Bucket One - Adequate liquid reserves

Recognizing that equity investments are too volatile to support even moderate withdrawal rates safely, investors must temper their portfolios with a near riskless asset that will lower the volatility at the portfolio level and be available to fund withdrawals during down market conditions. As a minimum liquidity requirement, I suggest high quality, short-term bonds sufficient to cover five to seven years of income needs beginning of retirement. While it is tempting to chase higher yields with longer duration or lower quality issues, past experience indicates that the enormous increase in risk swamps the small additional yield benefit.

So, if you expected to draw down 6% of your capital each year for income needs you might want to have 30-42% in fixed investments. That way if the market takes a dive, as it probably will sometime during your retirement, you will have plenty of time for it to recover. Meanwhile you can draw down the bonds. This protects your growth assets during market declines.

Bucket Two – World Equity Market Basket

Our second bucket will contain an approximate weighted world equity market basket. The design philosophy is to construct the equity portfolio with the highest possible return per unit of risk.

This investment policy recognizes the impact of volatility and employs standard portfolio construction concepts to reduce it. These well known Modern Portfolio Theory techniques include utilization of multiple asset classes with low correlations to one another. For example, I utilize nine distinct global equity asset classes. These classes each have high expected returns at tolerable risk levels and relatively low correlation to each other. We overweight the US for our domestic clients currency preferences, and overweight small and value stocks to increase expected returns while diversifying into dissimilar asset classes.

Frank Armstrong, CFP, is the author of Investment Strategies for the 21st Century, published here, President of Managed Account Services, Inc., a fee-only Registered Investment Advisor, and Chief Investment Strategist of DirectAdvice.com.

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