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By Alex Shingler, CFA & Justin Christofel, CFA
As multi-asset income investors, we seek to help a wide range of clients meet their income needs. The benefits of an income-centric approach are especially relevant for investors as they enter retirement – and that’s especially true today. We bring that to life with two case studies.
Why an income-centric approach matters in retirement: The accumulation vs. decumulation distinction
First, meet dollar-cost-average “DCA” Jay. He’s in his early 40s, in the middle innings of his career with another roughly 20 years before retirement. He’s squarely in the ‘accumulation’ phase of his investment journey, contributing regularly to his savings. On the other hand, we have “Distribution Deb,” a recent retiree. Since she is no longer earning a salary, she is relying on income from her investment portfolio to meet her cost-of-living expenses (in addition to income from other sources like social security and an annuity).
Equities represented by the S&P 500 Index, the 60/40 consists of 60% S&P 500 Index and 40% Bloomberg U.S. Aggregate Bond Index. Income portfolio consist of 33.34% U.S. bonds, 33.33% high yield and 33.33% value stocks, *Each contribution/distribution is increased by 3% each year to account for inflation. Dollar-cost averaging involves investing the same amount of money in a target security/portfolio at regular intervals over a certain period of time, regardless of price
Now let’s see what types of portfolios may be appropriate for these two very different life phases:
In accumulation, imagine that DCA Jay starts with $100,000 in the year 2000 and he manages to consistently contribute an inflation-adjusted $4,000 annually to his savings over the course of the next 20+ years. Despite weathering multiple storms over this accumulation period, be that the tech bubble, the Global Financial Crisis, or Covid, he would have been better off investing in the broad S&P 500 Index compared to a 60/40 balanced portfolio or an income-tilted portfolio (assuming he stayed invested throughout).
*Each contribution is increased by 3% each year to account for inflation
Source: Morningstar, of 3/31/23. Income portfolio consist of 33.34% U.S. bonds, 33.33% high yield, and 33.33% value stocks, the 60/40 consists of 60% S&P 500 Index and 40% Bloomberg U.S. Aggregate Bond Index. Index performance is for illustrative purposes only.
Index performance does not reflect any management fees, transaction costs, or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results. Case study shown for illustrative purposes only. This is not meant as a guarantee of any future result or experience. This information should not be relied upon as research, investment advice, or a recommendation regarding the Funds or any security in particular.
In the decumulation phase, it’s a very different story. Imagine that Distribution Deb has $1 million saved and a $40,000 annual portfolio income need. Starting at the same point in time as DCA Jay, weathering all the same market ups and downs, her potential portfolio outcomes are vastly different. Had she invested fully in the S&P 500, her starting portfolio would have lost over 90% of its value. Why? The reason is something we refer to as “sequence of returns risk.” In the early days of Deb’s retirement, markets – and her portfolio – suffered a major downturn with the tech bubble. Nonetheless, Deb still would have needed to meet her distribution needs (which are not met through the relatively low yield on the S&P 500 Index), meaning she had to sell a portion of her principal at exactly the time when her portfolio value was down, locking in these financial losses and making it difficult for her portfolio to fully recover as the market rebounded. Instead of dollar cost averaging, she experienced something we call “dollar cost ravaging”.
Fortunately, there is another story for Deb with a much happier outcome. If, instead of investing fully in the S&P 500, Deb had chosen to transition to a diversified income-oriented portfolio when she entered retirement, she would have been able to meet her annual income need primarily from the cash flow generated by the underlying investments, allowing her to leave her principal more intact and to ultimately participate in the market rebound over the coming years. In fact, her ending portfolio value would have actually grown from $1mn to $1.1mn over her decades-long retirement, all the while taking $40,000 in distributions each year.
*Each distribution is increased by 3% each year to account for inflation
Source: Morningstar, of 3/31/23. Income portfolio consist of 33.34% U.S. bonds, 33.33% high yield, and 33.33% value stocks, the 60/40 consists of 60% S&P 500 Index and 40% Bloomberg U.S. Aggregate Bond Index.
Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs, or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results. Case study shown for illustrative purposes only. This is not meant as a guarantee of any future result or experience. This information should not be relied upon as research, investment advice, or a recommendation regarding the Funds or any security in particular.
Why does this matter today?
The same sequence of returns risk that we saw impact Distribution Deb in the early 2000s is playing out as we speak. Following a challenging year like 2022 when both equities and fixed income delivered negative returns, Distribution Deb’s savings would have been particularly damaged had she remained invested in a non-income producing portfolio at the time of her retirement. Why? She would have started withdrawing principal when her portfolio value was down, which would have resulted in fewer future units and limited her participation in the market rally year to date 2023.
Bringing it all together: Consider taking a diversified, income-generating approach in the decumulation phase
So what does this all mean? As an investor’s life phase progresses, so too should their investment portfolio design. While growth equities and traditional balanced portfolios may very well be a good choice in the accumulation phase, a portfolio rethink is warranted for investors once they reach retirement and start to decumulate.
For illustrative purposes only
One way of mitigating this dollar cost ravaging, or sequence of returns risk, is by taking an income-centric approach. The BlackRock Multi-Asset Income Models Portfolios provide a core, diversified option for investors in their decumulation phase, and can be paired with income sources like social security and annuities. These models offer a number of benefits:
- Tap into a broad, diversified universe of income-producing asset classes including dividend stocks, investment grade and high-yield bonds, floating rate loans, covered calls, and more.
- This diversified approach allows the team to nimbly take advantage of market opportunities, constantly evaluating the income landscape and rebalancing on a quarterly basis.
- A whole portfolio solution available across multiple risk profiles to address the needs of all retirees, ranging from those early in retirement looking for more equity exposure to those focused more on capital preservation.
This post originally appeared on the iShares Market Insights.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
