Effective Strategies for Improving Retirement Portfolio Income
Like all investors, retirees want healthy risk-adjusted returns. However, retirees have an added need for reliable income because income is of paramount importance for investors who need to make regular draws from a starting amount of assets that is gradually drawn down over several decades.
While a relatively risky, high return investment such as U.S. stocks is generally a desirable component of an investment portfolio, it will typically provide less income over the long-term than a portfolio composed of stocks and bonds. In other words, the higher risk of large losses reduces an equity portfolio’s income potential versus a portfolio that contains a mix of stocks and bonds.
Why?
Mathematically, the critical requirement of a retirement or income focused portfolio is that it avoids large losses. It is this loss aversion characteristic that allows an investor to make regular draws over their entire retirement with a very high degree of certainty. Volatile equity portfolios violate the income investor’s need to avoid large losses. They expose investors to higher risk of large losses that in turn reduces the amount of income an investor can draw from their portfolio each month.
Maximizing Yield Through Dividends and Price Appreciation: A Guide for Retirees
There are two sources of income and yield: price appreciation and dividends. Retirees benefit from selecting the portfolio that is most likely to deliver their target income after adjusting for portfolio return uncertainty. The shorter the retirement span and/or the larger the asset base, the more a retirement portfolio can source yield from dividends. The longer the retirement span and/or the smaller the asset base, the more a retirement portfolio will need to rely on (risky) equity price appreciation.
With retirements becoming ever longer, there is an increasing need for portfolios that increase total retirement yield but without markedly increasing portfolio risk.
Retirement Yield Improvement Strategies: A Comprehensive Guide.
The foundation of efficient risk-adjusted returns is asset allocation based on diversification, achieved through an optimal blend of assets that have low or negative correlations with each other. Diversification can also include assets that have divergent payoff characteristics. For example, as we discuss below, there are many assets have similarly high returns but payoff at different times and in response to different risk factors. Diversification however is not a tool designed to produce the income outcomes the retirement investor is looking for.
By going beyond the basic tools of diversification and strategic asset allocation, tools which have existed since the 1950s, investors can further improve the income outcomes of their assets with portfolios specifically designed for those outcomes. This involves portfolios that reduce the exposure to large downside risks, or tail risks as they are often called, through risk management. It is especially appropriate to think about risk management in the context of retirement portfolios because of their high sensitivity to large losses.
Dynamic risk allocation is a systematic risk management approach that can increase income outcomes for retirement investors. It varies a portfolio’s exposures according to their risks. When the risk of an asset increases, the portfolio manager typically reduces risk exposure by selling some of the asset or hedging against it. Conversely, when the risk of an asset falls, the portfolio increases its exposure to that asset.
The intent of dynamic risk allocation is to reduce exposure to large drawdowns by maintaining a fund’s overall exposure to risk, even as individual security risks are rising or falling. Picture a sailor attempting to remain on course by adjusting a boat’s sails in response to a change in the wind’s direction or strength. Dynamic risk allocation is one way a portfolio manager can help retirement investors preserve capital and protect against losses while seeking to optimize risk-adjusted returns.
Similarly, systematic risk management and capital protection describe strategies, as described above, that are designed to protect against systematic, or market-wide, risks. These strategies seek to provide protection against the risk of large losses. There is a one-in-three chance of a major stock market crash occurring over any 10-year period. Given 30 and 40 year retirements these days, most retirees will likely to live through multiple periods of market losses over a typical retirement.
Systematic capital protection is a portfolio management approach designed to systematically avoid large losses in times of market stress by ‘following the major risks.’ The key components of systematic risk management include:
Identifying and monitoring exposure to sources of risk, including overall market risk, inflation risk, interest rates risk, and currency risk, and then;
Actively rebalancing the portfolio to control and reduce exposure to those systematic risks and potentially large losses.
Another approach to reducing exposure to large losses might be to attempt to time the market. Alas, the success rate of timing the market––buying and selling stocks, getting in and out of the market at just the right time–– is notoriously low. Too often, investors may be left out of the stock market at the wrong time, missing rallies. Empirically, it is very difficult for even professional investment managers to time the market and it’s unclear how strategies like this support the income mandate of retirees.
Another strategy is simply to buy and hold securities. Buy and hold is closely related to strategic asset allocation. Returns to buy and hold depend on what the prevailing market has in store. Investors must buckle up and go along for the ride, regardless of their income needs or the state of their asset base. While simple to operationalize, this approach can leave retirees highly vulnerable to large drawdowns like those experienced by many passive equity, equity/bond, and bond portfolios in 2022. Because of this, buy and hold strategies are more appropriate for pre-retirement investors than they are for investors seeking good income outcomes.
Smart advisors are not only strongly averse to style-drift but look for an investment process that is stable and repeatable. Investment process repeatability is probably the single most necessary characteristic of any retirement portfolio. If a candidate retirement fund/portfolio isn’t based on a repeatable investment process, the allocation decision becomes fraught with uncertainty and an advisor can’t know how much, if anything, to allocate to it.
Repeatable investment strategies solve for this problem by being systematic in the way they evaluate data, and size security exposures in response to incoming data. Generally, with repeatable strategies there is little room for discretionary decision-making and portfolio exposure decisions are made through a quantitatively driven investment process. Repeatable investment approaches can be particularly helpful to retirement investors because it’s precisely the lack of downside surprises that drives income in retirement.
Repeatability also makes the advisor’s job as an allocator easier. It allows the advisor to evaluate the fund/manager for potential allocation, knowing that the investment process that produced past returns, is the same investment process that will produce future returns. Past returns are never a guarantee of future results, but minimizing drift and the vagaries of discretion in the investment process provides for a more useful due diligence exercise and, ultimately, a more transparent and objective evaluation of performance.
It is important to consider portfolio tax efficiency when evaluating an investor’s retirement investment options. Gross returns are important, but what matters is an investor’s total net return over time, after fees, trading costs, and taxes are accounted for. Tax efficiency is a critical aspect of successful retirement investment management, not only for wealthier investors, who pay income taxes at a higher rate, but for retirees that are expected to have long retirements and have assets outside of tax-deferred accounts. Taxes are a compounding drag on wealth and therefore yield. All else being equal, over time, a portfolio with higher tax efficiency has a better chance of achieving investor objectives and goals than a less tax efficient portfolio.
Case Study: Reducing Exposure to Large Losses
2022 was a particularly difficult year for many income investors who invest in passive 60/40 type portfolios that do not provide any form of capital protection or downside risk management. In 2022 the 60/40 portfolio ended the year down about 17%. For a retirement investor, losing 17% of their wealth in a single year can be cause to reduce their income draw and enduring uncomfortable and unwanted lifestyle changes.
In contrast, our Markin Moderate Aggressive strategy ended the year down 10.3%, representing an approximately 40% cut in risk versus the un-risk-managed 60/40. The Markin Moderate Aggressive is a systematically managed strategy with a mandate of seeking to maximize income and yield outcomes by avoiding large losses. The strategy employs risk management methods like those described above to do this. By avoiding large losses, Markin retirement investors were better positioned to avoid any detrimental changes to their lifestyle in 2022. 2022 provides just one example of the value of reducing exposure to losses over a 30 or 40 year retirement.
Conclusion
Crafting a robust retirement portfolio demands a nuanced, analytical approach. Mitigating large losses is crucial for retirees who rely on regular withdrawals. We find value in looking for portfolio managers that employ repeatable, systematic investment processes and invest based on dynamic risk allocation principles. Markin Asset Management offers a variety of high yielding investment strategies to advisor clients. These strategies build on the income enhancing risk-management and downside protection methods described in this article.
About Markin Asset Management
Markin Asset Management is a diversified systematic manager that is active across alternative, multi-asset, and long-only equity strategies and funds. We seek to deliver outcomes that are aligned with the long-term goals of our investors. Our culture of combining quantitative and fundamental research, compute-intensive methods, and keenly focusing on the selection and management of risk exposures to enhance investor outcomes are distinguishing features of our firm. Markin is based in Rye, New York.
Want to learn more about how our investment strategies can benefit your practice? Contact us today, or schedule a time for an introductory chat to learn more.
The Markin Moderate Aggressive strategy launched on March 31, 2021 and is managed by Markin Asset Management LP (“Markin”). Results are based on fully discretionary accounts under management, including those accounts no longer with the firm. All investing involves risk, including the loss of principal. Past performance is not indicative of future results. The performance results shown are net of advisory fees and estimated transaction costs. The advisory fee is comprised of a 75 bps AUM annualized management fee. If we are serving you in a sub-advisory capacity the performance figures shown do not include any fees that may be charged by your primary advisor. The performance results shown reflect the reinvestment of dividends and other earnings. Additional information about Markin also is available on the SEC's website at www.adviserinfo.sec.gov.