As baby boomers approach retirement, the design of their portfolio changes. Growth becomes secondary to income. During retirement, income needs may be met by Social Security, private or public pension, rental real estate, sale of a business interest, inheritance and their portfolios.
These portfolios may be non-qualified (outside of a retirement account) or qualified (as part of a retirement account). Tax considerations may be important to the non-qualified account. For example, the investor may want to have dividends received here, as they are - under current tax law - favorable treated for reporting purposes. Interest may be better reeived within a qualified account, as it is taxed at the filer's tax bracket. K-1s can be a contentious item taxwise. Many would argue that they should be entirely within the non-qualified account. The result is a significant amount of tax free income at yields that are impressive. Their complexity requies more work, however, which work can be ignored in the qualified account. The discussion will continue. For the astute investor who is comfortable with the complexity of reporting requirements, K-1s from MLPs & BDCs are well received in the standard account. All of these retirement income sources must match or exceed lifestyle income needs. These income needs will be different from the income need while employed. It is vital to understnad your retirement income needs. They will change as retirement progresses, too. Travel, family, hobbies, the community become focal points for lifestyle initially. As retirement progresses, income needs tend to decline. Consumption falls off. Travel declines. Families visit. Community interests change.
Decade to decade, the income needs of the retiree decline. This occurs despite the challenge of inflation. If needs decline by 20% over 10 years and inflation increases by 10% over that same time, sources of income have to meet a smaller need.
Portfolio design for the retired individual must therefore meet the primary citeria of income creation - and reduce the growth demand. This happily meets the third requirement, enhanced security of principle.
The design of a retirement portfolio can be simple: half bonds, half stock. The debt side of the equation may be shared between government and corporate. Under 'normal' market circumstances, 'govies' may be 20-30%, with intermediate to long term maturities, These may be munis or BABs, looking for a distribution yield of 4 - 5%. Instiutional grade corporate debt can be 60 - 70% of the debt portfolio, with short to intermediate duration, looking for 5 - 6% yield. Lower quailty debt may make up the remaining 10%, striving for a net yield of 8%. Between the mix of the three, the yield should be 6%.
These mixes are best made with individual bonds. ETFs can often meet the income objective, but one has to be aware of pricing challenges that these face in the marketplace. Mutual funds should never be used for debt investing - the associated costs detract from yield. The risks of participating in a large portfolio include those of inflation, liquidity, management and market. The equity side of the income equation can be expected to distribute an 8% yield. Between the 6% net from debt and this 8%, the wise investor can realize 7% as distributable income from the portfolio.
Where can one get 8% dividends from stocks without inordinate risk? MLPs, BDCs, REITs, preferreds, a handfull of US & global equities. A well managed mix between these six equity arenas might include 15% in each category, leaving some funds in cash for emergencies or opportunities.
How does one manage this portfolio? Use of a 10% stop loss on each purchase, trailing it up for each 20% increase in stock price. This will create a stable, rarely traded portfolio. It will be one that forces itself out of the market when challenges arise. Re-entry can begin when the investor senses stability has returned. Purchases of out of favor stocks with significant dividend yields will enhance the portfolio return during the start of the next cycle, thus encouraging demand.
If the markets are so disrupted that the entire equity portion is forced to cash, the income stream will drop significantly. During such recessions, the consumer tends to spend less. The investor will also be spending less. The income need will be less. If capital is dipped into to meet income needs, that event surely will not have the same effect as staying fully invested in the equity markets and seeing 20%+ drops in capital accounts.
The design can be more complex, with the additon of insurance: TIPs, gold, sovereign debt, bank CDs. These might comprise as much as 5 - 10% of the total porfolio depending upon the designer's perspective of economic, political or regulatory risk.
The retirement investor has to be nimble, like the bamboo. Strong, yet flexible. Pliant but tough. For long periods, the portfolio platform may see few changes in its components. As a bond matures, a new one replaces it. As a stock's dividend or price changes, another stock replaces it. Once every few years a strong wind blows through the economy. The portfolio adjusts by increasing its cash, reducing its stock and its yield. As the threat passes, new growth of dividend income is revealed through the acquisition of out of favor dividend plays. The cycle begins again.
As time passes during retirement, the income needs of the retiree change, often declining with age. More conservative investments can replace higher yielding equities. The change is material, but reflects the individual's needs, rather than the vicissitudes of the marketplace. You do not have to beat the market, just participate in it.