Comfortable Aging

Your Retired Clients' Portfolios: ShouldThere Be a Difference?

as individuals age, the traditional historic approach to portfolio construction has been to reduce equity and other "risky" investments and increase fixed income investments. In a simplistic illustration, some use the following rale of thumb: Subtract your client's age from 100 and the result is the amount that should be invested in equities, with the balance invested in fixed income. A key question is: Would such an approach be in your client's best interest? Adhering to this method may reduce market risk, but it may not provide sufficient income and growth for those who are aging to ensur e that they don't outlive their assets.

Over the years, investment management and personal financial planning thought leaders have challenged this traditional way of doing things. Their academic studies and resulting opinions call into question the conservative approach. Within this article I will explore this issue, discuss client behavioral considerations and offer my own opinions.

Client Behavior

Individuals are living longer in the United States and other parts of the world. In 1940, when Social Security benefits were first paid, a 65-year-old typically lived about 12.5 more years. Today, a 65-year-old can expect to live about 18.5 more year s. Longer life spans mean retirees need more assets and longer lasting income streams.

How do retirees behave regarding their spending? Bud Hebeler, a retired engineer who has written extensively about elders investing and spending, says "People have to be aware that there is a large degree of uncertainty in their futur e financial situation. That includes uncertain returns, inflation, tax rates, health and many unknown events that escape foresight." There's also an assumption that the elderly spend less than those who are not in retir ement. "The elderly who have the money spend it," says Hebeler in an ar ticle titled "The Biggest Retirement Plan Myth."

Based upon my experience, and that of my peers who have served with me on the AICPA Elder Care Task Force, as people age and have less physical agility and mental cognitive ability, they don't spend as much money on such things as travel, entertainment, hobbies, country clubs, etc. However, costs of medication, medical care and long-term care can dwarf other such expenditures.

Breaking Tradition

So, what if the "traditional" stock/bond equation (or asset allocation) yields the wrong answer? Meaning, what if more total return is needed than can be provided with a traditional portfolio? In my 50-plus years of experience, I've concluded there are only thr ee tilings that matter: diversification, diversification and diversification.

The traditional wisdom, which states when individuals retire their portfolios should be structured ultra conservatively-either totally or with a very high proportion in fixed income securities-comes into question. There was a time when that approach may have been reasonable because of shorter life expectancies. Today, with people living longer, the impact of inflation-even at today's low rates-can have a profound impact on an elderly person's budget.

Furthermore, if planning is done merely to life expectancy, 50 percent of retirement plans will fail because 50 percent of people will five longer than life expectancy

How can we, as advisers, alter the traditionalists' mindsets about portfolio construction? Marry retirees may be more accepting of equities when they're not depending on the capital to generate cash flow each month.

I often recommend elderly clients consider a portfolio more closely aligned to that of a non-retired person. As guaranteed income generation can be an important aspect of portfolio structure, I will often recommend annuities-even though I'm not generally a fan them-as a way to provide a "guaranteed" source of income. I often obtain clients, usually widows or retirees, who have them.

The best choices of annuities are evaluated depending on the client's age and health. We usually find that annuitizing them over a term will accomplish providing a measurable portion of the required cash flow We can then more easily recommend an asset allocation that may assist with the retiree's growth and cash flow needs.

For example, we might provide for one year of cash needs in cash equivalents. Income and dividends will not be reinvested and they will partially or totally replenish the next year's liquidity needs. As this eliminates risks for the short term, the client may then be able to tolerate a more aggressively structured portfolio, if needed.

What do the Academics Say?

Robert Arnott, the founder of Research Affiliates, gave a presentation several years ago to the CalCPA Personal Financial Planning Committee. He argued that elders should have a sufficient amount in cash equivalents to make them comfortable-whether it's one, three or five years-with the balance in equities. His thesis was that even the worst bear' markets come back in a number of year's, and then move on to newer highs. History seems to prove his theory

Michael Kitces and Wade Pfau offered research showing an increasing equity "glide path" as one ages results in improved portfolio results which will enable retirees to better meet theh cash flow needs (http://papers.ssrn.com/ sol3/p apers. cfm?a bstra ct_ id=2324930).

In Iris article "The Best Asset Allocation for Retirees Initial Conditions and Optimal Retirement Glide Path Shape," (Advisor Perspectives, April 21, 2015), David Blanche« concluded that, when one uses long-term average bond and equity valuations, an increasing equity glide path appears optimal. However, when using the current environment in planning models, a decreasing equity glide path appears better.

Where To Go from Here

So, what should the retiree do and what should advisers advise? At the 2015 AICPA Advanced Personal Financial Planning Conference, James Shambo, a thought leader in the CPA financial planner community announced that he was retiring at the beginning of 2016. His presentation was a case study of where he is and where he will be in retirement. As usual, lois presentation was loaded with great tips, anecdotes and projections.

At the end of lois presentation I asked him if he planned to use an increasing equity glide path, á la Kitces and Pfau, for his retirement portfolio. His pointed response: "Hell no!"

How do we put this discussion in perspective? There have been disparate opinions and academic research performed in portfolio allocation for elders and retirees for decades, all of which suggests different conclusions. Yet, there is as much ait as there is science to such asset allocation construction.

Human behavior must be a part of the equation. If someone knowledgeable, such as Shambo, can conclude, "Hell no," to a higher equity glide path, and if brilliant researchers can reach different conclusions on the same topic, then we, as advisers, must take all of these opinions and distill them into the advice and counsel that we provide to oui' older and retired clients so they will be able to come to their own conclusions about portfolio allocation.

The goal is for them to have secure retirements. Secure can be as much psychological as financial.

How can we, as advisers, alter the traditionalists' mindsets about portfolio construction?

BY MITCHELL FREEDMAN, CPA/PFS

Mitchell Freedman, CPA/PFS is CEO of M FAC Financial Advisors, Inc. and M. Freedman & Co., Inc. an Accountancy Corporation. Helsa member of the CalCPA Personal Financial Planning Committee.You can reach him at [email protected].