Giving the retirement planning playbook a much-needed second look

For decades, today’s retirees have been following the same asset-allocation strategy: from concentrating on equities in their youth, they should gradually dial back their allocation and shift toward bonds to provide fixed income in their sunset years. But according to Paul de Sousa, that playbook has lost a lot of its power.

“I think fixating on income, especially when interest rates are at generational lows, is quite dangerous,” the senior vice president and investment advisor at Sightline Wealth Management told Wealth Professional. “Make no mistake, these low rates represent a large tax on investors, and it's a war against savers.”

According to de Sousa, a typical $1-million bond portfolio could have generated a reasonable amount of cash flow 20 years ago. But following that strategy today, he said, may lead to excessive reductions of equity exposure – a dangerous move in the current investing landscape.

With rates being just a fraction of what they were back then, nest eggs today need to be several times larger than 20 years ago to throw off the same level of income. In grasping for the fixed-income return rates of decades past, advisors and investors might possibly even venture into riskier areas of the bond markets. Add to that the prospects of inflation and longevity risk, and retirees today face a very real threat of having less cash flow than expected in their later years.

“Income investing, in the truest sense of the phrase, really limits your investment universe,” he said. “I think advisors should put more focus on cash flow, which is ultimately what an investor requires and opens up various other asset classes.”

For advisors working with clients at or approaching retirement, the updated investment management playbook would consist of maintaining different siloes within their portfolios. In one silo, they should have an exposure to equities, particularly those with a low down-market capture ratio.

“With an alternative investment that has consistent distributions and / or capital gains and low downmarket capture ratios, an advisor also has the option to withdraw part of the capital gains quarterly or semi-annually to produce cash flow,” he said.

Another important pitfall to avoid for near-retirees and retirees, de Sousa said, is sequence of returns risk. When conducting a sensitivity analysis on the equity silo of the portfolio, advisors should seriously consider the possibility of a near-term correction, particularly with a view to its possible duration and depth. A sustained or severe drawdown in equity markets, he noted, could force advisors or investors to draw on their stock holdings to generate cash flow.

“What you want is to build a strategic cash reserve, which provides at least a year or two of cash flow,” he said. “Ideally, you’d have other assets in that silo that generate cash flow in the forms of dividends, capital gains, and interest. The idea with that bucket is to enable a long-term approach for investors to ride out inevitable declines.”

Another silo, he said, should provide income through other asset classes such as mortgages, dividend-paying stocks, and even private debt. de Sousa encourages advisors and investors to reinforce efforts at diligence, oversight, and monitoring as their main line of defence.

“As a whole, it’s a wonderful asset class, but not all investments are made equal,” he said. “I advise everyone to not just stop once they see the label of private debt, but really roll up their sleeves and look under the hood. For the managers we use, there has been extensive due diligence – learning about their process, their operations, and the typical loan of their loan book – and double-checking what we’ve been told before placing any money with them.”

One other source of complexity in using private investments, he said, is the difference in their liquidity profiles. While some allow investors to redeem with one month’s notice, others might demand three months, six months, or even a year before they can give investors their money.

Given the illiquid nature of the underlying assets, which can be real estate, mortgages or longer-term loans, the lockup periods associated with private investments are understandable. Beyond that, they can be beneficial: aside from making investors less likely to sell when they’re in a panicked state, they provide for an illiquidity premium that can be attractive relative to many other asset classes.

“Planning around private investments means considering the needs and options of the client for liquidity,” de Sousa said. “Do they have any needs for the short term? Are they planning to draw a portion of the portfolio? Is there perhaps a fund for unexpected emergencies that they don't have to liquidate?”

When implementing the asset-allocation strategy he suggested, de Sousa said advisors should also not fall prey to single-outcome thinking. Pundits may sound the alarm on large market crashes ad nauseam, or call a boom and say the Dow will go to the moon. Typically, however, some variation or blend of market and economic predictions winds up happening – and as the world negotiates a turning point in the COVID-19 pandemic crisis, the stakes are higher than ever.

“I think we're at a crossroads in terms of the vaccination rollout, and the economy opening up. There are a few theories on how that will play out,” de Sousa said. “This market has also been completely held together by the Fed liquidity since last March; unprecedented amounts of money have entered the system. So what happens when the Fed starts to taper? What happens if interest rates start to slowly rise?”