This is the final part in a four part series exploring the usefulness of tactical strategies across generations.  The first three parts of the series focused on MillennialsGeneration X and Baby Boomers, respectively.  Today, we will discuss Retirees.  Our one-pager on Retirees can be found here.

The word “retirement” conjures up different ideas for many people: family, healthcare, hobbies, part-time work, relaxation, relocation and travel, to name a few.  Regardless of individual plans for retirement, the concept of a “comfortable” retirement is likely to ring true to across the board.

Income sources like Social Security and pension plans are generally not able to meet the income requirements for most retirees today.  That’s why 40+ years are spent investing income from our careers – to provide us with the retirement we desire when that income is no longer present.  In the previous parts of this series, we discussed how tactical solutions can help with this long process of accumulating a portfolio for retirement.  Once retirement is reached, the portfolio must finally be put to use.

Retirees are currently facing a dilemma: how does one produce income from a portfolio without taking on excessive risk to capital?  Conventional wisdom dictates that investment portfolios are de-risked in retirement to protect capital so that they can generate consistent replacement income; short-term fluctuations become a much larger burden without regular contributions to the portfolio from employment income.  However, the graph on the one-pager shows that 10 times more risk must be taken in 2014 than in 2008 to achieve a 4% yield.  While de-risking is important, it must be done differently in the current economic environment to meet investors’ goals.

With yields at near-historic lows, not only is income generation using traditional methods difficult, but capital may be at risk when rates inevitably rise.  The yield on the iShares Core U.S. Aggregate Bond ETF (AGG) is currently ~2.2% with a duration of 5.25.  Therefore, if rates rise by 1%, we can expect the value of the portfolio to decrease by approximately 5.25%.  This price decrease more than wipes out the benefit of a higher yield.  Contrast this with a higher starting yield in 2005, when AGG was yielding ~4% with a duration likely below 5.1  In this scenario, the higher yield would make up for the price drop in less than one year, which may be tolerable in the retirement portfolio, especially since rates subsequently rose for only a few years.

We can take it one step further and say that if we anticipate a prolonged period of rising rate (similar to 1962-1981), we have even grimmer prospects with a traditional fixed income portfolio.  From 1962-1981, the 10-year constant maturity Treasury index lost nearly 50%.  Since these rates started at 4% in 1962, compared to ~2.6% today, a rate increase of comparable magnitude would likely hurt capital even more, without the benefit of the higher yield realized in the 60s and 70s.

This unique low and rising rate environment makes tactical strategies a particularly attractive way to pursue income generation in retirement while preserving capital.  Using tactical strategies that seek income from alternative sources to traditional fixed income can mitigate duration risk while smoothing out portfolio income by selectively taking advantage of market tailwinds.

1. The duration is assumed to be lower than it currently is since the duration of bonds is lower when interest rates are higher (positive convexity).

Nathan is a Portfolio Manager at Newfound Research, a quantitative asset manager offering a suite of separately managed accounts and mutual funds. At Newfound, Nathan is responsible for investment research, strategy development, and supporting the portfolio management team. Prior to joining Newfound, he was a chemical engineer at URS, a global engineering firm in the oil, natural gas, and biofuels industry where he was responsible for process simulation development, project economic analysis, and the creation of in-house software. Nathan holds a Master of Science in Computational Finance from Carnegie Mellon University and graduated summa cum laude from Case Western Reserve University with a Bachelor of Science in Chemical Engineering and a minor in Mathematics.