[This article appears in our October 2018 issue of ETF Report.]
You spent years building your nest egg, hoping to achieve financial security in retirement. Then suddenly you find yourself here. Retired. Accumulation phase over. Now what?
Investing doesn’t stop because your working days are over, but it takes on a different focus as withdrawal rates take center stage, and managing downside risk—losses you may not be able to recover from—becomes critical.
Unfortunately, there’s no universal recipe for what your ETF portfolio should look like once you’re retired. Asset allocation at this point hinges on individual, specific-to-you metrics such as how much money you need, how long you need it and how much risk you can tolerate.
Kevin Grogan, director of investment strategy for BAM Advisor Services, puts it this way: “The right asset allocation is a function of a person’s ability, willingness and need to take risk.”
Some of those things can change as you move from career to retirement, he says, but the broad guideline is pretty intuitive. According to Grogan, the ability to take risk is largely a function of time horizon—you’re probably more able to take risk if you need your money to last, say, 10 years versus 30 years.
The willingness to take risk naturally goes down the older you get, because going back to work to make up for market losses may not sound all that appealing. And finally, the need to take risk is directly linked to how much money you plan on spending relative to how much you’ve saved.
Before digging into what ETFs you might consider owning to make sure your nest egg passes the test of time, piece of advice No. 1 is: Determine your spending.
There’s a lot of literature on what your withdrawal rate should be, and varying opinions, but many still subscribe to the so-called 4% rule, or “Bengen rule.”
First introduced by financial advisor William Bengen in the early 1990s, the idea is that, in retirement, you can take 4% of your assets in the first year and keep that up, adjusting for inflation every year thereafter, and see your money last at least 30 years.
Mitch Reiner, COO and senior investment advisor at Capital Investment Advisors in Atlanta, recently tested this theory with different asset allocations, and came out a believer, finding 70% of the time that retirement assets lasted at least 50 years, and at its worst, 29 years, if you spend your money at a 4% rate in today’s world.
Income, Income, Income
Once you have that spending rate figured out, the key, he says, is to shift your investment focus from equity returns and portfolio value to income generation. Even in your stock allocation.
“In retirement, you should decouple yourself from performance, S&P 500 returns, and from a focus on the bottom-line value of your portfolio,” Reiner said. “Transition to looking at the consistency of the income being generated in your investment account.”
“Different asset allocations perform differently using the 4% rule,” he explained. “The reality is, the returns associated with equities give you a better chance of success. But if you only need 2% of your entire investment portfolio and you’re super conservative, then you don’t need but 20% in equities. If you need 4%, and you only have 20% in equities, you’re going to challenge yourself. Your withdrawal rate is key in all of these asset allocation conversations.”
Not All Equities Created Equal
Look for an asset allocation rich in income producers, be it stocks, fixed income or even real assets. Reiner’s guide map begins with a good equity allocation in retirement.
“I’d want a 30-50% allocation to equities—that’s kind of a standard I’d tell my parents they should have, even at an older age,” Reiner said. “But you can have that allocation in stocks that look like bonds.”
Think stalwart dividend-paying stocks like Procter & Gamble, Johnson & Johnson and Southern Company,
“Your ride is going to be a lot different than if you had your money in the technology sector, funds like the Technology Select Sector SPDR Fund (XLK). Owning stocks isn’t just owning stocks,” Reiner noted.
A good mix of ETFs for a retiree, according to Reiner, includes funds such as:
SPDR S&P Dividend ETF (SDY) for capturing dividend growers.
SDY invests only in a select group of companies from the S&P 1500 universe that have grown dividends for at least 20 years. The securities are then yield-weighted. The fund, with $16.2 billion in total assets, has a current distribution yield of 4.71%, according to FactSet data. It costs 0.35% in expense ratio.
Vanguard International High Dividend Yield ETF (VYMI) for a higher yield as opposed to total return out of your international equity allocation.
VYMI is a global ex-U.S. dividend strategy that ranks companies by forecast yield over the next 12 months, investing in those expected to deliver high yields relative to the average. Securities are weighted by market capitalization. VYMI has $968 million in total assets and costs 0.32%. Current distribution yield is 3.70%, FactSet data show.
First Trust North American Energy Infrastructure Fund (EMLP) for its blend of utilities and master limited partnerships (MLPs) as part of an income strategy.
EMLP is an actively managed MLP strategy that reaches beyond MLPs and into utilities and pipelines to meet 1940 Act rules. The strategy, with $2.3 billion in total assets, has a current distribution yield of 3.8%. It costs 0.95% in expense ratio.
Invesco CEF Income Composite ETF (PCEF) for a good proxy for closed-end funds, which, unlike ETFs, often trade at premiums or discounts since they’re closed for new creations.
PCEF invests in different types of CEFs focused on yield. The strategy looks for CEFs trading at a discount in order to capture value appreciation and higher yields. Current distribution yield sits at 7.17%. PCEF has $726 million in total assets and costs 2.07%.
Vanguard Real Estate ETF (VNQ) for diversification on the income side through REITs.
Securities like REITs can have strong appeal relative to traditional bonds in a rising rate environment. VNQ is a classic in the U.S. REIT segment, boasting $33 billion in total assets and a low price tag of 0.12%. Distribution yield currently is 4.25%.
New Way Of Thinking
“You have to train yourself to think about your money in a very different way,” Reiner said. “It’s a scary time when you go from adding and growing to taking money out of it and having to sustain it. But the questions are: How can I get a consistent amount of income out of my assets? And how can I build a portfolio that does that automatically without dependence on success of the market?”
The pitch for an income focus is hardly unique when it comes to investment advice for retirees. But different advisors and strategies offer different takes on the same quest for sustainable income.
John Thomas, chief investment officer of Global Wealth Management, works with a big retiree clientele in Ft. Lauderdale, Florida, and he says growing income comes with a warning.
Yes, focus first on generating income through securities such as dividend-paying stocks that are growing dividends, but keep an eye on valuations and capital preservation.
“You want to make sure you’re getting a raise and keeping up with inflation in your dividend payers,” Thomas said. “But you can’t have all investments in dividend growth, because then, all of a sudden, you have perhaps too much growth and not enough value in the portfolio.”
To that end, he says ETFs that achieve annual income growth but also keep the asset allocation balanced between growth and value—as some dividend payers are “pricey right now”—include:
iShares Core Dividend Growth ETF (DGRO) for steady, sustainable increase in income.
DGRO picks stocks based on dividend, dividend growth and payout ratio, looking for companies that have been consistently increasing dividends for at least five years, but that do it at a sustainable rate. The fund, with $4.3 billion in total assets, is cheap, at 0.08% in expense ratio. Current distribution yield is 2%.
Vanguard High Dividend Yield ETF (VYM) for high-yielding stocks.
VYM is a market-cap-weighted mix of dividend-paying stocks ranked by their dividend forecast for the next 12 months. The $22 billion ETF has been around since 2006, and costs only 0.08%. Distribution yield currently sits at 2.8%.
iShares Select Dividend ETF (DVY) as another alternative in the high-yield space.
DVY is a dividend-weighted basket of U.S. companies delivering sustainable income. The strategy looks for dividend growth, as well as payout ratio and history to find stocks that are paying high dividends and can keep doing so sustainably. With $17.4 billion in total assets, DVY costs 0.39% and currently delivers a distribution yield of 3.06%.
Good Ol’ Bonds
Beyond dividend payers, Thomas also suggests mixing in REIT ETFs as an alternative to long-term bonds. Generally speaking, the rising rate environment isn’t all that great for long-term debt, he says. Still, consider sticking with some traditional classics while mixing duration exposures to mitigate interest rate risk.
His picks on the fixed-income side are straightforward: the $56 billion iShares Core U.S. Aggregate Bond ETF (AGG) and the $1.4 billion iShares 0-5 Year Investment Grade Corporate Bond ETF (SLQD), which owns corporates with zero- to five-year remaining maturity.
“In retirement, you can’t focus on average returns anymore. You have to focus on protecting on the downside and getting enough upside to generate your income needs,” Thomas said. “You can get good returns with more reasonable diversification, and really lower your overall risk in the portfolio.”
“You’ve got to temper your enthusiasm on whether your portfolio is a matchup with the S&P 500,” he added. “If you’re doing as well as the S&P 500 in retirement, then you’re taking too much risk.”
Target Downside Mgmt With Real Assets
One big concern facing retirees is the possibility of inflation and its erosive impact on capital. One way to try and manage inflation risk is through “durable” and “real” assets. David Schassler, head of VanEck’s portfolio and risk solutions group and portfolio manager, makes a concise case for owning both the S&P 500 and real assets in retirement. Both types of assets come with risks, and VanEck has a pair of funds designed with downside protection in mind.
“Most investors would benefit from some exposure to the S&P 500, because it’s a very durable asset, but there are times when you don’t want to be too invested,” he said. “We use things like trend, mean reversion, sentiment and macroeconomic factors to identify periods that are likely going to be associated with drawdowns.”
The result is ETFs such as the VanEck Vectors NDR CMG Long/Flat Allocation ETF (LFEQ) that toggle between an S&P 500 allocation and Treasury bills, depending on market conditions. Ultimately, the goal is to take cues from technical indicators and mitigate losses in market downturns.
LFEQ came to market last October, and it has amassed $42 million in assets, and has a price tag of 0.59%. The young and novel strategy competes with other ETFs that take on the task of managing downside in equities. Among them is the Innovator Lunt Low Vol/High Beta Tactical ETF (LVHB), which rotates between S&P 500 High Beta Index and the S&P 500 Low Volatility Index based on relative strength. LVHB has $133.5 million in total assets and costs 0.49%.
Another fund in the VanEck lineup, the newcomer VanEck Vectors Real Asset Allocation ETF (RAAX), tries to capture the benefits of real asset investing through a lower-volatility mix of real estate, infrastructure, commodities and natural resource equities, many of which are attractively valued relative to fixed income. The fund can also go all into cash as a downside protection mechanism.
“We all know inflation robs savers of spending power, and right now we’re late cycle,” Schassler said. “At late cycle, that’s when you have periods of strong global growth, and rising inflation. That’s the point of the cycle where real assets typically outperform other asset classes.”
“From a retiree’s perspective, living on fixed income and being exposed to an inflationary environment, having some exposure to real assets could make sense,” he added. “That said, they’re very volatile assets. So, like everything else, it’s OK in moderation.”
Launched this past April, RAAX is still in its infancy, with only $14 million in total assets, but it’s not the only game in town. Competing ETFs in this alternatives ETF space include funds such as the SPDR SSgA Multi-Asset Real Return ETF (RLY), which also blends different assets to hedge against inflation, and has $143 million in assets. There’s also the 20-month-old QuantX Risk Managed Real Return ETF (QXRR), which also can go all into cash, and has $7.2 million in assets.
3 Key Takeaways
It goes without saying that this isn’t a comprehensive list of ETFs that could meet your retirement investing needs. There are more than 2,100 ETFs listed in the U.S. today, and a lot of them are big, liquid, well-run, tax efficient and cheap. You have choices aplenty.
If these tickers don’t do it for you, others might. But keep in mind three little nuggets as you evaluate your asset allocation.
Firstly, fees matter in security selection, especially during retirement. You can only spend your net-of-fee return, as Grogan says. Tony Watson, CIO of Detroit-based Portfolio Solutions, goes one step further, saying low-cost index funds and index ETFs are “always the right vehicle,” under any circumstance. “We don’t believe in active management or spending extra money in an attempt to gain alpha here.”
Secondly, even the best ETF choice can’t overcome an ill-constructed spending plan. Accurately assessing your withdrawal rate is of paramount importance to the success of your asset allocation.
“Really put a lot of effort into coming up with that spending number, because far and away, the biggest driver of success of a financial plan is how much you’re spending relative to how much you’ve saved,” Grogan said. “There’s nothing we can do on the investment side or with the asset allocation that’s going to overcome an extremely high withdrawal rate. It’s the withdrawal rate that makes the most difference.”
Finally, remember we are all only humans, and retired or not, behavioral biases can eat your nest egg.
“The biggest risk facing retirees is behavioral biases,” Watson said. “They’ve worked their entire life for these nest eggs, and they’re very afraid of losing it. That heightens those behaviors that negatively influence all investors.
“When times are good, people think they can handle risk, but the real question is, if we have another 2008-2009, and equity values fall by 50%, are you going to be tempted to sell, and take equity risk off the table?” Watson said. “If the answer is yes, that’s a problem, because you’re going to have irreparable damage done to the portfolio. The key is having a really efficient diversified portfolio.”