With an aging population, advisors are frequently asked what the secret is to building a retirement portfolio that can provide higher current income and inflation protection while sustaining capital. While there is no sure-fire answer, investors should consider embracing capital-efficient strategies designed to protect capital in an effort to avoid large losses during negative market cycles.

In addition, approaches should focus on generating retirement income from the cash flow created by interest and dividends, not by liquidating capital.

As advisors, we must help clients find effective strategies that will help them achieve their goals in an underperformance cycle characterized by low price appreciation.

Today, more than ever, advisors need to pay attention to recent evidence that indicates dividend-paying stocks, not growth stocks, should be the foundation on which portfolios are built.

One of the first things we learn as advisors is the importance of the present value of a dollar, or having the largest capital base possible working for you at all times. Investors who get to retirement with the largest capital base to produce income have a good shot at enjoying a decent quality of life.

Yet the passive "buy and hold" allocation approach with no active management component inherently disregards the capital destruction caused by negative market cycles. Controlling risk can help retired investors capture more consistent return, while also seeking to protect capital invested in volatile securities.

A significant loss of capital while investors are withdrawing income can cause compound liquidation to occur as investors sell greater number of shares each month as prices decline to meet income needs. Studies indicate that the markets suffer a correction of 20% every four years and a 40% correction every six years on average. During these periods of negative price momentum, investors using a systematic withdrawal approach would very likely liquidate so much capital they would outlive their income stream.

Historically the market has provided investors with an average rate of return of 10% annually. But many people don't realize that the market goes through long-term performance cycles, averaging 17 years that can provide underperformance or outperformance to the historical average.

Market volatility turns systematic withdrawal plans using growth stocks into the evil twin of dollar-cost averaging, which I call "dollar-lost averaging." In its mildest form, dollar-lost averaging increases the risk of outliving capital. As capital declines and retired investors continue to make withdrawals to meet their income needs, an investor's capital base may become so compromised that it may never recover.

So far investors have lost, not made money, during this underperformance cycle that started in 2000. This year's market action has been even more frightening to retired investors who are depleting the remaining value of their investment accounts to pay their bills.

An investor who invested $100,000 in the growth-stock-focused Nasdaq in 2000; (the beginning of the current secular underperformance market trend) would have completely liquidated their account by January of 2009 by taking a 5% systematic withdrawal adjusted for the average annual inflation rate of 2.42% for the period. The S&P 500 Index fared only slightly better, ending 2010 at $28,441 for a 72% loss in value.

Ideally, retirement income solutions should be designed using a balanced blend of bonds and high-yielding, dividend-paying stocks to generate interest and dividend income to support withdrawals. A balanced blend of 50% Dow Jones Corporate Bond Index and 50% S&P 500 stocks held up materially better, ending 2010 at $78,770. Instead of relying on systematic withdrawals for growth, a balanced portfolio seeks to produce current income from interest and dividends generated by the portfolio's underlying investments.

The amount and sequence of returns drive capital growth or loss. Portfolios producing more consistent positive returns have a positive effect on the growth of capital.

Less Volatility

One of the big selling points for dividend-paying stocks is that they are often a safe harbor during uncertain times. Not only can clients count on the steady and reliable return from dividends, but also dividend payers tend to be less volatile. The old idea that dividend stocks provide less return than growth stocks is being discarded as new research is published. During these uncertain times, advisors need to shore up investors' portfolios with high-yielding dividend stocks that can not only be less volatile, but offer investors a return from dividends that is not at all dependent on price appreciation.

During secular bear market cycles, dividends can create the path to positive returns. We believe investors should get paid to wait for stock prices to appreciate. That's why dividend-paying stocks, not growth stocks are the building blocks of our portfolio construction process. They will likely need every penny saved to generate income to help support lifestyle expenses during retirement.

A balanced approach anchored with dividend-paying stocks tends to satisfy their risk concerns, while also addressing income and inflation needs. While bonds don't keep pace with inflation, the higher income they generate can be combined with generous dividend income which tend to increase over time to help keep pace with inflation. When price appreciation returns to markets, stocks can be sold to further increase income in an effort to fight inflation. With the vast majority of investors getting closer to retirement and becoming more risk adverse, advisors should create balanced portfolios using a mix of bonds and high-yielding dividend stocks to potentially increase return and reduce risk.

Baby boomers are the largest U.S. population segment, and, as they retire, their risk tolerance for any loss of capital declines dramatically. We have had several clients celebrate "century" birthdays." Investors typically save and invest for 40 years while they're working. Just a few short years ago investors would have needed a retirement income stream to last for a maximum of 15 to 20 years.

With increased longevity, clients may need income streams to last for 35 years or longer. Investing to generate income and inflation protection with the least possible risk to capital has always been the most difficult investment management problem to solve.

Many traditional investment approaches are completely out of sync with seniors needs. Many products are still focused primarily on growth investing without regard to the effects that volatile price returns can have on capital balances.

While U.S. corporate fundamentals have been positive, both stocks and bond prices have taken a hit this year, offering up attractive values and yields. Active risk management (using stop-losses for stocks and active duration management for bonds) can further immunize portfolios from market downturns and keep shaky investors comfortably invested.

Today's investors are desperate for investment solutions that actually help them achieve their goals while preserving their investment capital and income streams. Advisors who adopt these new solutions while shunning the conventional growth-focused passive strategies that continue to fail investors, may find the world beating a path to their door.

 

Don Schreiber, Jr. is Founder and President of WBI Investments Inc.,
which manages $850 million for advisors and individuals using dividend-paying stocks.
He is co-author of the book, All About Dividend Investing,
and can be reached through www.wbiinvestments.com