Using Total Return to Meet Your Clients' Income Needs

Throughout the 1980s, 1990s and 2000s, many financial plans were constructed with the assumption that the portfolio could produce enough income to allow for 4 to 5% annual withdrawals during retirement. Over the past 35 years, interest rates have fallen around the globe and today bond yields are too low to meet a typical 4-5% annual withdrawal from a retirement portfolio.

Today the ten year U.S. Treasury bond yield is around 1.9%; ten years ago this yield was about 2.5 times higher and was around 5%¹. Of course an investor can stretch for higher yield, but this invites additional and often unintended risks; whether it be credit risk, maturity or duration risk and/or other unforeseen portfolio threats such as liquidity and issuer concerns.

Today’s dividend yields are also at relatively low levels compared to historical payout rates. The current dividend yield of the S&P 500® Index is 2.1% compared to the long term average of 4.4%². With both interest and dividends rates so low, how do we as an industry meet our client’s retirement living needs? We believe the answer is a Total Return strategy.

The concept of using total return to meet retirement income needs is relatively simple. One starts by combining the dividend and interest income from the portfolio and supplementing this with, usually modest amounts of, capital gains. If executed properly over time, the combination of the two can create adequate income, positions the portfolio to keep up with inflation and maintains a more stable asset base over time.

Equity returns over short time periods have, and likely will, vary widely. Since 1945 the long term annual growth rate for the S&P 500 has averaged about 7.2% before dividends³. We are going to be more conservative and assume equities will grow at 6.0% per year over time. The 6% annual growth over time (CAGR) is split into two with each half being assigned a different task: 3% will be used for supplemental income and the other 3% will be tasked to grow and keep up with inflation.

What about equity risks?

All markets, especially equity markets, undergo periods of failure. To account for this risk, we further recommend two additional policies to complete this overall strategy:

First, we would mandate 2-3 years’ worth of income needs to be invested in cash and ultra-short bonds so when markets do fall, such as during 2008-09, there is sufficient cash available to meet client income needs during these downturns. Knowing that there is a secure income source that is not exposed to typical market volatility
helps mitigate client anxiety and helps prevent additional drawdowns when the investment’s prices are depressed.

As an example, let’s use a $1 million portfolio, and a $40,000 annual income need which is 4% of the portfolio. If the portfolio were to drop 30% to $700,000, the same $40,000 would represent a 5.7% withdrawal. Given the historical 2-3 year time period that most bear markets have lasted, the markets would be well on their way to recovery and our portfolio’s stock and bond principal would still be intact and poised to recover. Having this cash reserve allows the investor to leave the portfolio alone during the bear market and assumed recovery period.

Second, for the equity portion of the portfolio, we would recommend investing a portion in tactical vs. strategic management. Using tactical management as a piece of the portfolio allows part of the equity allocation to avoid at least a portion of the drawdowns that occur during bear markets. This can shorten recovery time and reduce client anxiety even further, and keeps the client from making emotional buy and sell decisions.

As an example, the table below uses a $1 million hypothetical portfolio, a 4% annual income need and assume investing in low cost, long only ETFs to represent each asset class to show how this would work:

The example has 2.5 years of income allocated to either a money market or ultra-short bond ETF; while $300,000 of the portfolio is allocated to other bond ETFs. Of this, the example would recommend investing ½ passively in a low cost bond index ETF such as the Barclay’s Aggregate Bond Index ETF (AGG) and ½ in an actively managed bond ETF, such as the SPDR DoubleLine Total Return Tactical ETF (TOTL), where the manager has the ability to seek additional alpha during most bond market environments.