Advisors face a problem that’s very personal to Morningstar’s Christine Benz: the chase for yield.

Clients often seek income and advisors want to give it to them — potentially setting up a situation where yield trumps all else. Fortuntately, there’s a potential solution for advisors to consider.

Benz, Morningstar’s director of personal finance, saw this issue firsthand. She recalls how one of her retired relatives didn’t want to touch any of his invested principal. He was focused solely on yield — placing income above all other goals of a portfolio, including diversification and growth. He would often buy potentially risky bonds from individual issuers lured by yields alone, putting his overall plan at risk.

Benz, Morningstar’s director of personal finance, saw this issue firsthand. She recalls how one of her retired relatives didn’t want to touch any of his invested principal. He was focused solely on yield — placing income above all other goals of a portfolio, including diversification and growth. He would often buy potentially risky bonds from individual issuers lured by yields alone, putting his overall plan at risk.

“I got nervous thinking about his portfolio,” Benz told Capital Group at the Investments and Wealth Institute conference in Nashville. “He was very income-centric.”

Chasing income can cause investors to start “gravitating to their peril” toward assets that might have higher yields, but put the portfolio out of balance. It’s a risk more advisors will need a plan to deal with.

Factors fueling income chasing

Advisors may find clients eager to ignore calls for a diversified portfolio as they search for yield, due to three factors:

• Interest rates remain historically low. Relatively low rates persist — although the yield on the 10-year Treasury briefly rose above 3% this year. Investors looking for higher levels of income have been pushed into riskier investments to compensate.

Yields have ticked up
But they’re still relatively low

Source: Thomson Reuters. As of 6/29/18.

 

• Pensions are vanishing for many workers. The number of defined benefits plans in the U.S. fell to 45,672 in 2015, half the number that existed in 1975, according to data from the U.S. Department of Labor.  Lacking a pension, many investors seek income from their defined contribution retirement accounts.
  
• Investors aren’t saving enough. 401(k) account balances average $189,387 even among those closest to retirement — workers in their 60s with 20 to 30 years of work tenure, according to the EBRI/ICI Participant-Directed Retirement Plan Data Collection Project. “A 4% withdrawal rate from such a portfolio just isn’t going to cut it for most retirees,” Benz says.

Time for a new mindset: Three-bucket approach

Facing these challenges, advisors need to blend a strategy for income while still exposing portfolios to long-term growth, Benz says. “I have been a big believer in helping retirees get off this income-only mindset and think about it as cash flow.”

To make this happen, Benz suggests framing porfolios with three buckets — based on time frames. Not only does this help organize a portfolio to meet cash needs, but it’s also a way to explain the portfolio’s structure to clients.  “It’s a nice way to back up and explain, ‘Here’s why I’m doing roughly what I’m doing,’” Benz says.

• Bucket 1: Near-term needs. For very near-term expenses — those due in two years or less — this money needs to be left out of the investment portfolio. Cash or near-cash investments are best here.
  
  The role it plays: Most clients should put enough cash in this bucket to cover a couple of years worth of portfolio withdrawals — after factoring in Social Security or possibly a pension for a baseline of income.
  
  Consider a retiree who spends $60,000 annually, but who is earning $32,000 a year from Social Security. Holding $56,000, or two years of estimated portfolio withdrawals, in this bucket might be prudent, Benz says.
  
  Older retirees who have near-term needs for income might be overweight in this bucket. But it’s not just older clients, younger clients planning to make a large purchase like a house in a few years should fill this bucket as well.
  
  A side benefit: Adding this bucket to an allocation can also address the so-called sequence of returns risk. This is the risk of a poor market environment happening shortly after a client retires. If retirees sell investments at depressed levels early in their plan, that can increase their odds of running out of money. If they pull from this bucket instead — and keep invested money untouched — the results can be improved long term.
  
  
• Bucket 2: Intermediate needs. For needs beyond the next two years, but less than 10, this bucket applies. This is a place for high-quality bonds.
  
  The role it plays: This is an important bucket for new retirees who maintain low initital withdrawal rates. Use it to hold investments that should be ready for retirees as income needs increase.
  
  
• Bucket 3: Long-term needs. This is where advisors can allocate the part of portfolios not needed for a decade or longer, Benz says. Advisors can focus on adding asset classes with track records of having generating returns needed to keep up with retirees’ long-term needs. It’s ideal for “primarily stocks, but maybe some lower quality, non-core fixed-income investments like high-yield bonds or emerging markets bonds,” she says. When considering high-yield or emerging markets bonds, investors should maintain a long-term perspective since these types of securities can fluctuate in price more than higher rated bonds.
  
  The role it plays: This is the long-term growth engine for retirees, which supplants the need to chase risky investments with relatively high current yields. Selling investments in this bucket can refill bucket 1 when it is depleted.

Advisors can consider this approach to keep investors focused on the future and avoid chasing short-term ways to boost yield. “This idea of structuring a portfolio based on having a positive return over whatever our spending horizon is can be really powerful,” Benz says.

Video