Ask an Expert - Retirement Income | The Center for Due Diligence

Q: Putnam recently introduced a series of absolute return funds designed to deliver positive results with less volatility than traditional funds over a three year period. The 100, 300, 500 and 700 funds were designed to outperform the rate of inflation by a similar amount in basis points. These funds have captured about $500 million and they are now adding them as components of their target date RetirementReady Funds. Is this the Holy Grail or another gimmick? I still remember the disaster called "Government Plus Funds."

DIFFENDERFFER:

Tough question! Putnam has a disappointing history of new concepts for fund management. However, under new leadership, the Putnam of today is a very different company. Robert Reynolds recruited Rob Bloemker and Jeffrey Knight to manage the funds, two of the strongest teams in the Putnam stable.

Absolute return funds are not new and because they underperform relative return portfolios over time, they have delivered uneven results. Frankly, if time is not an issue, why sacrifice return? It is also important to note that absolute return is a goal, not a guarantee. Critics suggest the name implies a guarantee and as a result, some feel FINRA should consider restricting the use of the term. Nevertheless, it does not invalidate the strategy as a way for investors to control volatility.

Historical data suggests that most responsible withdrawal strategies (4-6%) from multi-asset portfolios will work in the absence of dramatic portfolio draw-downs and that is the primary goal of retirement age investors. Reducing volatility is also the foundation of the target date glide path. Recent market performance confirms that adjusting the relationship of equities to fixed income in relative performance based portfolios is not enough. Non-traditional asset classes such as real estate, commodities and currencies have been added to portfolios in an attempt to reduce volatility.

Managers are no more likely to meet the goal of absolute return than they are to beat an index, but transitioning from relative performance based strategies to absolute return based strategies makes sense. Putnam's inclusion of the Absolute Return Funds as components of their RetirementReady Funds also represent a logical evolution for target date funds.

In short, the final determinant will be execution. If Bloemker and Knight can execute their models, time sensitive investors may be well served. Nevertheless, Putnam would be wise to undersell absolute return portfolios and focus on portfolios with sustainable withdrawals. After all, that is what investors are really seeking.

On a final note, real analysis requires a real portfolio. Back testing has never been an accurate predictor of performance. As asset managers shift resources to lifetime distributions, i.e., the ultimate end game, many similar products will be introduced in the years ahead.

Q: Managed payout funds were launched just before the market collapsed. NAVs are down 30-40%; distributions have declined 20-30% from projections and represent return of principal. What happened to these funds and is there any reason to consider them?

DIFFENDERFFER:

The failure of managed payout funds has not been a failure of execution, but rather a broad market decline across almost all asset classes. Most of the funds will no doubt recover when the markets recover. A lack of conceptualization and design is the real failure of these funds. What most investors and advisors want is multi-asset portfolios that are managed for the added risks of consistent distribution demands. What they got is traditional asset allocation portfolios with an internal systematic withdrawal plan attached. I would be cautious with these funds until their sophisticated asset management techniques focus on risk reduction rather than performance. These funds should be focusing on absolute returns rather than beating an index.

Q: The current market has decimated retirement accounts. Target date funds have done little to protect one’s ability to retire on schedule. The recently launched managed payout funds have also not done well and annuity providers are raising fees and lowering benefits for GMWB riders. What are the best options available for advisors that will help individuals plan for and survive retirement?

DIFFENDERFFER:

The most important lesson of the 2008 market meltdown is the realization that the industry can’t meet the needs of the retirement income market by teaming guarantees and/or distribution mechanisms with accumulation oriented portfolios. As the maturity date approaches, target date funds must change both the asset allocation model as well as the asset management strategy. The tools may be similar, but the design, structure and implementation must be focused on risk/volatility control rather than outperformance. The current financial market conditions are extreme. The outcome is unknown and all approaches are facing extraordinary pressure. The current models were designed to maintain integrity during normal market cycles. This is not a normal cycle. All markets are dynamic and follow a pendulum swing from undervaluation to overvaluation and back again. This principle is also applicable to financial equity, debt, real estate and commodity asset classes along with growth, value or dividend income strategies. The greatest safety mechanism is perhaps the acceptance of uncertainty. Meanwhile, advisors should seek solutions and products which are flexible enough to meet today’s challenges and adapt to future needs.

Q: Are there any guaranteed income options available in the 401(k) plan market? What is on the horizon that may help?

DIFFENDERFFER:

With the caveat that guarantees are only as good as the guarantor, there are some new product offerings for the qualified retirement plan market which offer selected portfolios and come with a lifetime guaranteed minimum withdrawal benefit (GMWB). For example, the John Hancock Guaranteed Income for Life (GIfL) product is similar in concept to the GMWB riders offered in retail variable annuity products with the exception of costs. The John Hancock retirement program is a group annuity and the GIfL takes the form of a participant selected rider to the group annuity. Thus, there are no additional M&E fees, resulting in attractive pricing. The guarantee for single coverage is a 5% annual lifetime withdrawal benefit, which is reduced to 4.5% when including the life of the spouse. Participants have a choice of John Hancock lifestyle asset allocation portfolios and John Hancock managed fund of funds portfolios.

Q: I have been hearing about low volatility portfolios. What are they and who offers them?

DIFFENDERFFER:

The current market conditions have put new focus on low volatility (also called managed volatility) asset management strategies. These strategies invest in low volatility stocks to control risk while attempting to earn market returns. State Street Global Advisors, JPMorgan Asset Management, Analytic Investors and Acadian Asset Management have recently developed portfolios based on this concept. Ric Thomas, Managing Director of Enhanced Equities at State Street Global Advisors, has developed some compelling data on domestic and global low volatility portfolios. Advisors might be well served by considering portfolios of this nature in retirement plans. The strategy may underperform benchmarks during bull market conditions, but the risk management should appeal to conservative investors. Going forward, low volatility strategies could play a bigger role in the equity exposure of multi-asset allocation portfolios in the retirement income market. Retirement income portfolios should focus on managing volatility and not on outperformance. The inclusion of low volatility strategies that reduce the sequence of return issues seem to be an obvious choice. Because low volatility strategies tend to have a high degree of tracking error, benchmark oriented investors may prefer other strategies during bull market conditions, but income oriented investors should remain comfortable with the consistency of their returns.

Q: I have been using retail annuities with Guaranteed Lifetime Minimum Withdrawal Benefits (GMWB) as a rollover vehicle for my clients. Now that the markets are down 40%, clients taking the 5% annual withdrawal at the original contract value are happy to have their income protected. What do I do for the clients who aren’t taking distributions? The original plan was to wait for annual step-ups before starting withdrawals to meet RMD requirements at 70 ½. If possible, should I have the client add to the accounts? I also have clients with non-qualified annuities. What would be the best strategy for them?

DIFFENDERFFER:

Adding to an account that is down 40% because of market conditions is normally a sound idea, but not in this case. If the client is eligible, it would make sense to immediately start taking the 5% GMWB payment and reinvesting the distribution into a new contract, assuming of course the client still wants a guarantee. The dollar value of the 5% GMWB will not increase until the current market value of the contract increases 60%. Using an example of a 64 year old with a rollover of $100,000 reduced to a current market value of $60,000, the GMWB would be $5,000 a year for life. Until the $60,000 recovers to above $100,000, there is no increase in the $5,000 distribution. However, if the GMWB is taken every year until the client reaches 70, the $30,000 reinvested in a new contract with a 5% GMWB would have an additional $1,500 per year guarantee without growth in the market value. This would be true in both a qualified and non-qualified annuity contract. In the qualified annuity contract, the GMWB distribution would not be taxable if it is taken as a distribution into a rollover IRA. In the non-qualified annuity contract, the distribution of the GMWB would not be taxable until the value of the annual distributions and the year end market value of the contract exceed the original $100,000 contract value. Should the investor want to add more, the additional money should be invested in a new contract.

Q: With talk of an extended recession and even a depression, my clients are scared. To protect against a worst case scenario, I have been considering principal protection funds. What is your opinion?

DIFFENDERFFER:

These funds typically draw attention when fear is great. However, it is important to remember that the principal protection only relates to a specific future maturity date. In other words, the investment has market risk until that date. These funds tend to have high fees and asset management is constrained by the principal protection goal. You can accomplish the same goal by split funding a period certain fixed rate annuity and an index fund. For example, $78,353 invested in a five year fixed annuity at 5% (you can shop for the most competitive rate) matures at $100,000. The balance of $21,647 could be invested in an S&P 500 index fund. If the index fund drops to zero (highly unlikely), the client would still have the $100,000 protection at maturity. (The amounts can be adjusted to cover taxes.) The fees would be lower with this approach and the client gains liquidity on the index investment component.