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Practice Management

As one advisor found, planners need to know how to do much more than build wealth for their clients.

This Practice Management article is intended for financial advisors only (registered representatives of broker dealers or associated persons of Registered Investment Advisors).

Helping investors live off their wealth is a very different business from helping them build wealth. But managing retirement income is something every advisor needs to learn how to do—and soon.

With about 10,000 baby boomers turning 65 each day, our industry will soon be dominated by the concept of retirement income management. That means you'll need to change your investment and business operations to meet the changing needs of your clients in an era of low (and sometimes negative) investment returns.

Over the last decade, as more of our clients were moving into their retirement income phase, we noticed that they had investment objectives and service needs much different from the needs of our clients who were still accumulating wealth. In fact, we determined that it was taking about twice as much work to manage the retirees' finances, yet we had to do it for the same fee. That meant we had to become more efficient and focused if we wanted to profitably serve this client base.

We identified three primary areas where we were doing the most additional work: portfolio management, distribution planning and investment tax management. The key to managing these aspects of our practice efficiently was to commit to one portfolio structure for retirement income clients. That then allowed us to streamline the distribution planning and tax management.

Portfolio Management
In the late 1990s, not many advisors recognized retirement income management as a separate style of investment management. Because market returns were so good, the plan was simply to use capital gains to produce the distributions. If your portfolios returned 15% a year, you just distributed 6% and your retired clients were probably fine. Thus you could run the same portfolio for clients who were building wealth as those who were living off it.

But you can't do that now with retired investors. Stock prices have declined for many of the past 11 years and we're facing record low interest rates. We may well be in for another decade of subpar financial market returns, and capital gains probably won't save your retired clients. That means you're going to need a specific investment strategy for retired clients that can meet their objectives. You've then got to run that strategy across your client base so that you can efficiently manage the portfolios as well as the distributions and the taxes.

Once we came to this realization several years ago, we developed a model portfolio that was based on the four common objectives of our retirement income clients:

  • Current income
  • Growing income
  • Principal protection
  • Long-term capital gains

Those objectives are listed in order of priority, meaning they are not all equal. For instance, current income is more important than long-term capital gains. Why? Because if our investment strategy were to produce capital gains 15 years from now, that would be nice - but the client who had no income during all those years would be in big trouble.

S&P 500 Is Not the Benchmark
Because retirement income objectives are so different from what clients were accustomed to in the wealth accumulation phase, it's been hard to get clients to understand the appropriate risk-and-return profile for their accounts. We got tired of investors bringing up the performance of the S&P 500 as a benchmark for accounts and thus an implicit stamp of approval for portfolio structure.

Anyone who works extensively with retirement income strategies knows that relative returns are meaningless to retired investors. If the S&P 500 drops by 50% and our clients are down by 49.5%, we can congratulate ourselves on a relative basis, but our clients will probably be running out of money. We needed a different approach to help clients understand why they needed to convert to a different portfolio structure.

Because we could not find an investment benchmark appropriate for retirement income management, we decided to create our own retirement income index that was based on our investment strategy. We developed the Farrell-Northstar Retirement Income Index ( It comprises securities that are selected for their ability to help meet the objectives of retired investors.

The index, which we worked with S&P's custom index program to design, debuted on June 30, 2008. Of course, we had no idea what sort of market mayhem we were in for over the next several years, but there could not have been any better proving ground for our index.

From inception through October 31, 2011, our index had an annualized total return of 7.93% and had rising cash flow throughout that period (the S&P 500 had an annualized total return of 1.61% over that same period). The index also provided significant principal protection, declining about 16% in price from inception to the depths of the financial crisis in March 2009, compared with the 45% decline of the S&P 500 over the same time frame. Our index met its objectives of current income, growing income, principal protection and capital gains, during arguably the worst markets we've seen in 80 years.

The index currently comprises about 50% dividend-paying equities and 50% high-quality fixed income. The average yield on our index has fluctuated between 3.5% and 4% depending on market conditions since the index launched. Currently, our average stock dividend yield is about 3.6% and dividend payments have been growing at an annual rate of about 7%.

When building retirement income portfolios, we attempt to hold the securities that are in our index, and thus the index serves as the foundation for our model retirement income portfolio. Over the last three years, all of our new retired clients have been going into our retirement income model portfolio, and we've been moving our existing clients to the same portfolio structure.

This has made an enormous difference in our ability to manage the portfolios and serve clients efficiently. We now know the basic return profile for each client every month, the cash flow produced that month and the downside exposure clients have during market meltdowns.

Our retirement income investment strategy may not work for your firm, of course. But the main point is to develop a strategy and consistently apply it.

Distribution Planning
It takes a great deal of work to process monthly distributions for a large group of retired clients. If we couldn't process the distributions efficiently, then the administrative work would bury our business. Now that our retirement income clients are all in one portfolio structure, we can determine the sustainable distribution amount for each client easily without having to engage in complicated assessments of each client's performance and account holdings.

On a macro level, by setting cash minimums and being able to estimate monthly cash flow, we can schedule distributions without a lot of individual portfolio analysis. If clients didn't have similar portfolio structures, then we'd have to figure out on an individual account basis what cash flow is available, what to sell when the client needed a distribution (each month), and how to adjust allocations after any sales. This account-by-account analysis would overwhelm us. Without a common portfolio structure for your retirement income clients, you'll find it difficult to serve a large retirement income client base profitably.

Tax Management
In general, tax management for retired clients comes in three phases. The first is positioning client assets in different types of taxable accounts to lower their effective tax rate on distributions. The second is managing the monthly taxable transactions, meaning understanding when to take distributions—and from which accounts—each year. And the third phase is managing the required minimum distributions from qualified accounts.

Once you realize the depth of the planning required, you understand that retirement income management has its own investment tax structure, which will require a substantial commitment of your time to master. You can't dabble in this area and expect to run an efficient practice. You've got to know the rules and have a focused tax protocol that you apply across client relationships.

If you operate one portfolio structure, tax management becomes a much easier process, although it is still challenging. By working with one set of investments, it's easier to decide where to position certain assets, such as which ones go into a rollover IRA and which ones go into a Roth IRA. It also gets easier to estimate total tax rates for clients because you know the amount of qualified dividend income, capital gains and ordinary income generated by the investments.

The key to the business model is to commit to one portfolio strategy. That will allow you to manage the investment, distribution and tax planning process for retired clients efficiently. Without that common portfolio strategy, you're likely to find yourself buried in a mass of investment, distribution and tax problems that will smother the profitability of your practice.

Charles Farrell is a principal of Northstar Investment Advisors in Denver and author of Your Money Ratios: 8 Simple Tools for Financial Security.


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