Retirees can generate income and preserve capital at the same time
When it comes building a retirement-income portfolio, retirees are often faced with a seemingly insurmountable challenge: They have to figure out how to generate enough income from their nest egg to support their desired lifestyle and do so without running out of money over the course of their household’s lifetime.
And on paper (and in reality) it’s difficult to do both; you seemingly have to sacrifice one goal in favor of the other. Either you draw down enough income from your retirement accounts to support your lifestyle and risk outliving your assets or you reduce your standard of living in retirement and sleep soundly at night knowing that you will never run out of money.
A new study from Rob Isbitts, the founder and chief investment strategist of Sungarden Investment Research suggests that it might be possible to have your cake and eat it, too. By combining traditional investing with alternative investing, or what’s called hedged dividend investing, you can generate income and preserve capital. Plus, you can have long-term growth and liquidity and do so without having to spend a fortune on this strategy.
“The most vital and pervasive issue retirees will face in the next decade is how to wring out enough income from the savings they have amassed to maintain or enhance their lifestyle,” wrote Isbitts. “They have been presented with an enormous amount of information from financial advisers and financial media, but finding confident solutions to their issue is proving elusive.”
Existing solutions fall short
According to the paper, “The Sungarden Study: Combining Traditional and Alternative Investing to help Address the Retirement Income Problem,” retirees can no longer rely on using high-quality bonds to generate income in retirement. That mainstay of retirement-income planning for the past three decades now poses, Isbitts wrote, a significant challenge in the form of historically low investment income rates. What’s more, the potential exists for interest rates to rise, which would push bond returns into negative territory, wrote Isbitts. And that would complicate the ability of retirees to invest effectively in retirement.
In addition, Isbitts wrote that traditional a stock-and-bond portfolio (the sort built using modern portfolio theory), or target-date funds, or bond ladders offer some benefit, but often fall short of being comprehensive. “They (don’t) sufficiently guard against both interest rate risk and risk of a major stock market decline,” he wrote. (Read an excerpt from the study, Chutes and Bond Ladders .)
And that leaves the door open, he wrote, for innovative solutions which take advantage of current conditions instead of assuming that past will be prologue. “It’s our view that one relevant solution to today’s retiree predicament involves pairing together two ‘natural enemies’ — dividend-oriented stocks and a ‘hedge’ which effectively moves counter to the broad stock market,” he wrote. “Essentially, a long-short portfolio whose long side aspires to produce a competitive income yield and a short side which aims to reduce the impact of major market declines.”
And it is this long-short approach that focuses more on income than most traditional and alternative investment products today that should replace the stock-bond combination used by many retirees, wrote Isbitts.
Want proof? In his study, Isbitts took the basic underpinnings of long-short approach and “stress tested” it over the past 20 years to see how the concept stacked up against traditional investment approaches.
In his study, he constructed an index (the Sungarden Hedged Dividend (SHD) index) with 80% allocated to the S&P 500 Dividend Aristocrats Index, an index which includes members of the S&P 500 that have increased their dividend payments each year for the past 25 years, and 20% allocated to a mutual fund — the Rydex Series Trust Inverse S&P 500 RYURX +2.07% — that aims to move in the exact opposite direction of the S&P 500 SPX -0.77% . And then he established a protocol for rebalancing the index; anytime the allocation moved outside a five percentage point threshold.
And what he discovered is this: His SHD index outperformed the traditional 60%/40% allocation over 20 years, (8.65% vs. 8.2%) and other indexes, particularly on a risk-adjusted basis. In addition, the risk-adjusted return figures showed that the SHD index produced an “alpha” of nearly 3% over the S&P 500. In other words, the returns of the SHD index vs. the stock market were driven in large part by the “skill” of the simulation, wrote Isbitts.
“This is perhaps the strongest evidence in the study that adding a hedge component to an equity portfolio has the potential to produce enormous value to the investor when consistently executed over long market cycles,” wrote Isbitts.
And one of the key takeaways of his study is that investors should consider replacing their bond exposure with a hedged dividend strategy, according to Isbitts. “This can help shield them from the worst impacts of rising rates (by avoiding bonds) and stock market turmoil (since the inverse position offsets some of the damage to the stock portfolio in bear markets), wrote Isbitts.
What about the income forgone by not using bonds? Well, that, he wrote, is replaced and potentially exceeded by the dividends produced from the stock portfolio.
In fact, retirees would have been able to withdraw 4% a year from their nest egg to support their lifestyle given that the SHD index generally had returns greater than 8% a year over the time over the time period studied.
To be fair, there were times in Isbitts’ back testing when the SHD index produced returns that were highly inferior to those of the broad stock market. And given that, Isbitts suggested that investors should not blindly follow this two-security model.
“Rather, they should glean from (this study) the idea that combining dividend-oriented stocks with a hedge on the broad stock market is a viable approach, but is not complete without an active management component,” Isbitts wrote.
According to Isbitts, that active component is a matter of personal choice; it could either be a more rigorous, research-driven stock selection approach or more of an “overlay” on top of the basic long-short investment mix.
At the moment, some might say that Isbitts is ahead of his time, but that’s not his point of view. “It’s our view that hedged dividend investing is a concept whose time has come,” he wrote. “Amid the opaque collection of strategies essentially being rebranded as ‘retirement-income’ portfolios, we think that a combination of a back-to-basics approach to the attractions of equity dividends, married with the straightforward approach to volatility management described (in this study) offers tremendous benefits for retired and pre-retired investors.”
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