Editor’s Note: John Graves has been an independent financial advisor for 26 years. He is one of the two owners of The Renaissance Group, a Registered Investment Advisor based in Ventura, CA. John’s book, The 7% Solution: You Can Afford a Comfortable Retirement, was published in 2012. When I read this book, I was impressed with John’s approach and thinking and I recommend it as a good read. I contacted John and asked if he would consider contributing to this blog. After we bounced around some possible topics, he sent me the following piece that describes his process for designing income plans for retirees.
Income investing - is it the challenge of our Age, or something simpler? I would argue the latter.
Begin with the first step, continue on, and stop when you have arrived: an old Japanese proverb.
How much do you need during retirement? How much does your client need during retirement? As a disciple of the ancient IDS church of financial planning (IDS was where Ameriprise came from: a 100 year old fund and CD company in Minneapolis, absorbed in 1994), I begin the first step with asking a new client about their expenses today. We spend some time here. My goal is to listen to them discuss expenses, rather than the actual figures themselves. I want to hear how they talk about money between themselves. Yes, I do make note of the figures. We use them as the basis for retirement projections of course. But rather than simple straight-line projections into their distant future, I suggest changes as time passes. Income sources change; expenses change; family, travel, health issues arise; as we mature, we spend less. Counterintuitive? Not really. As you mature, you travel, eat, buy and generally consume less each decade.
With this first step you have identified a range of expense potential for your client's future. Ab initio, you have the basis for portfolio design - in my world. You see, I live in a fantasy world. There are no dreaded acronyms: MPT, AA, EFH. These beasts roam other jungles - perhaps yours - but never mine. In my fantasy world, portfolios are built up from each family's income need. As long as that need can be expressed quantitatively as a figure less than 7% of the client's capital portfolio, we can take our next steps.
We have a matrix of choices from which we can derive the income we need. Some are extraneous to my portfolio skill set: Social Security, rentals, trust(s), settlements, winnings, inheritances. We discuss these as income faucets, to be turned on as needed. For example, we always want to delay SSI until age 70, all else being equal. We want to pay off mortgages - on the home or on rentals - to maximize real cash flow. You will never convince me that I can do a better job with capital than simply eliminating the home mortgage. Pay it off!
The portfolio(s) is designed to supplement these income sources. In fact, it may be the primary source, but by rendering it as support of their retirement income, it fits well into most people's thought processing. It is simply another tool in his garage, on her kitchen shelf: a financial tool.
From the universe of choices in today's marketplace, we must choose which tools best suit each client's private capital world. The choices are: bank CDs, annuities (fixed, immediate, variable and index), mutual funds, ETF/ETNs, non-traded investments (hedge funds, REITs, MLPs, BDCs, 1031s, etc.) and my personal favorites - stocks and bonds.
Moving forward, we now have the project, the design, the tools and the skill (that would be found in my book, The 7% Solution, You CAN Afford a Comfortable Retirement). Now you must build to the client's need. For example, consider the case of someone who wants $6,500 monthly income at age 62, has rentals netting $1,200 per month, with a $270,000 mortgage costing $2,345/month. In addition, this person has a projected severance package of $65,000 and bank CDs of $245,000 laddered over 2 years earning 1.9%, with a total retirement portfolio of $650,000. If you pay off the mortgage with your bank CDs and the net from the severance package, this will increase your monthly income by $2,345. You can now design the portfolio to a distribution yield of 5.4%, or $2,955 monthly. These sources will give you the $6,500 income you seek.
Now, how do you, the advisor, put this type of portfolio together?
You stay ahead of their income need curve each year by communicating. That means listening twice as often as you speak - you have two ears, one mouth; use them accordingly.
First, defer SSI until 70 – it’s like having an 8% zero coupon government bond.
Now for the quantitative portfolio considerations. You want to build a stable of stocks with low debt-to-equity (D/E), low price-to-book (P/B), strong free cash flow (FCF), dividend coverage ratios of >1.25, a history of sustainable dividend payments, and a culture of community support (local workers, suppliers, capital expenditure, etc.).
I firmly believe in using stop losses set at 10% below the purchase prices of individual investments. If a stop loss hits and a position is sold, you need to re-deploy that cash in a timely manner to maintain your income.
For the bond allocation, I prefer a ladder of individual bonds to the use of bond funds. There are many reasons, but primary among them are expenses, turnover, style drift, and absolute performance through time.
Aside from stocks and bonds, it is worth becoming familiar with MLPs, REITs, and other pass-through entities, as well as preferred shares. You can find appropriate candidates at a number of websites. I like quantumonline.com, finviz.com, seeking alpha, dividend detective.com, and divideninvestor.com.
It is crucial to manage taxes by choosing which assets you hold in taxable vs. tax deferred accounts. You can also reduce your tax burden in how you draw income on your portfolio.
Details and examples can be found in my book, but the main criteria are what’s right here.
Even in the current low-yield environment, there are enough viable candidates to build a portfolio which would reach a 5.4% yield at a fairly modest level of risk. More yield is achievable if someone is willing to take more risk. The goal, however, is to take only as much risk as you need to.
The journey never ends, of course, and any financial plan needs to be adaptable. For the professional advisor, we are constantly learning through example and through error. Remember that Barry Bonds was paid millions for a 70% failure rate (hitting .300). If yours is that good, play ball!
Eat wisely. Sleep well. Love with abandon!
The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. John Graves is not affiliated with FOLIOfn or The Portfolioist.