| What a difference a year makes. People entering | | | | an exchange, as the former have far fewer |
| retirement early last summer had a strong | | | | reporting requirements. Greenbaum and Orecchio |
| market to boost their nest eggs and cushion any | | | | employs three full-time professionals whose sole |
| anxiety over their life transition. On July 19, 2007, | | | | job is to evaluate private investments and do the |
| the Dow Jones Industrial Average hit a record | | | | related legal work. |
| high, closing above 14,000 for the first time. To | | | | Endowment Products for the Rest of Us |
| the extent that the subprime crisis had even | | | | Over the past year, the financial services industry |
| registered, most observers expected the damage | | | | has introduced new products to help consumers |
| to be contained within the housing sector. | | | | generate retirement income and to capitalize on |
| The investment outlook has darkened since then, | | | | the wave of retiring baby boomers. Endowments |
| however, especially for those who may not have | | | | inspired the design of at least one of the new |
| decades ahead to smooth the effects of volatility. | | | | retirement income mutual funds on the market: |
| Regardless of how the markets perform, most | | | | The Vanguard Managed Payout Funds, launched in |
| retirees count on withdrawing income regularly | | | | early May. The three funds of funds target |
| from their nest eggs, while preserving as much of | | | | payout rates of 3%, 5% and 7%, respectively, |
| their principal as possible. | | | | while maintaining capital, and in this approach |
| On an institutional level, foundations face a similar | | | | function something like a university endowment, |
| task. Congress requires them to give away at | | | | Vanguard executives say. The underlying funds |
| least 5% of their assets each year; their challenge | | | | are Vanguard stock and bond funds, and other |
| is to grow principal to keep pace with inflation, so | | | | investments, including REIT and TIPs |
| they can meet commitments to grantees and | | | | (inflation-protected Treasury bonds) funds and |
| cover operating expenses. It's like retirement... in | | | | commodity-linked investments. |
| perpetuity. "The problems of the retired investor | | | | Vanguard's approach contrasts with that of |
| and of the endowed institution are very closely | | | | Fidelity Investments, whose new payout mutual |
| related," says Laurence Siegel, director of | | | | funds are designed to liquidate an investor's |
| research in the investment division of the Ford | | | | principal by a target date. Vanguard chose its |
| Foundation. "Both seek to produce an income | | | | approach because "there was a sense generally |
| stream that grows with inflation." | | | | that there's a strong desire among retired clients |
| You don't need to invest your clients' nest eggs | | | | to preserve their capital in liquid form for the |
| exactly like the Rockefeller or Ford Foundations-to | | | | duration," says John Ameriks, a Vanguard principal |
| say nothing of Harvard or Yale. In fact, most | | | | and economist. Vanguard's research among the |
| investors can't act like Harvard or Yale, despite | | | | company's mutual fund shareholders reveals that |
| the books and articles that espouse to teach | | | | many older people continue to save in retirement. |
| how-they just don't have enough money. But | | | | "It's very hard for people to turn on a dime in |
| foundations and endowments can teach advisors | | | | retirement," Ameriks says. "They've been saving |
| strategies for constructing and maintaining | | | | their whole lives." In other words, even if your |
| retirement income portfolios. Here's a look at how. | | | | clients aren't saving enough for retirement, their |
| All-Important Allocation | | | | saving habits are nonetheless ingrained. |
| Retirement income planning didn't even exist a | | | | According to the Vanguard funds' prospectus, the |
| couple of generations ago. Through the mid-20th | | | | 3% payout fund is expected to appeal to |
| century, most people didn't have a decades-long | | | | investors who want to see their capital and |
| retirement, for the simple reason that life | | | | payouts increase over time and seek only a |
| expectancies were shorter. People stopped | | | | modest current payout from their assets; the |
| working, lived a few years on Social Security and | | | | 7% payout fund, on the other hand, is expected |
| then died. Later on, in the 1980s, retirees could | | | | to appeal to those who need a greater payout to |
| pack their portfolios with double-digit-yielding | | | | satisfy immediate spending needs. While the |
| Treasury bonds and bank certificates of deposit | | | | payments and capital on the 7% fund are not |
| and live comfortably off that income. During the | | | | expected to keep pace with inflation, Vanguard |
| same decade, as inflation cooled, a bull market | | | | will seek to preserve the fund's original value. The |
| began that persisted for the rest of the century. | | | | 5% fund is designed to provide long-term inflation |
| Today, the picture is decidedly more complex. | | | | protection and capital preservation. The funds |
| People are living longer than ever. The life | | | | could function as the investment vehicle of a small |
| insurance industry has adopted new actuarial | | | | endowment, and in fact, Vanguard has fielded a |
| tables reflecting this: As of January 1, 2009, all | | | | few inquiries from such institutions, Ameriks says. |
| policies must be issued with rates that extend | | | | The funds' payout rates are targets, not |
| through age 121, replacing tables that end at age | | | | guarantees. "These products are not annuities," |
| 100. And the markets are less friendly. Market | | | | which offer a guaranteed income stream for life, |
| watchers predict that stocks may languish for | | | | Ameriks notes. "There are positives and negatives |
| years in a range-bound market that provides | | | | to that." The company believes that positives, |
| none of the oomph of the bull market that ended | | | | such as liquidity and flexibility, outweigh the lack of |
| in 2000. | | | | a guarantee. Indeed, annuities have failed to gain |
| Meanwhile, people's spending needs haven't | | | | widespread acceptance in the marketplace largely |
| changed-if anything, they've risen, as healthcare | | | | because consumers are loath to relinquish access |
| costs have exceeded inflation-and inflationary | | | | to their principal. |
| pressures have mounted. Yet 30-year Treasury | | | | But Then Again... |
| bond yields hover under 4.50%. | | | | As much as retirees and foundations share similar |
| Recent research reinforces the importance of | | | | challenges, there are some noteworthy |
| asset allocation in retirement as one of the | | | | differences between the two. For starters, |
| safest, most efficient ways to meet long-term | | | | individuals die. No one needs to produce income in |
| portfolio needs today. Because of compounding, | | | | perpetuity, as foundations endeavor to do. |
| more than half of every dollar that's withdrawn | | | | Retirees need to plan for at least 30 years in |
| from a defined contribution plan comprises | | | | retirement, and annuities can insure they won't |
| investment returns generated after retirement, | | | | outlive their assets. Amid the general unpopularity |
| according to a study conducted by Russell | | | | of these insurance products, advisors and their |
| Investments and released last month. The study | | | | clients often overlook the benefits provided by |
| looked at a prototypical 25-year-long retirement | | | | risk pooling. "Annuities produce a much higher |
| of a 65-year-old who dies at age 90. Out of each | | | | income than bonds or TIPs because the people |
| dollar the retiree withdrew from a defined | | | | who die help pay for those who survive," Siegel |
| contribution plan, 10 cents came from | | | | explains in his email. In fact, you need 25% to |
| contributions made to the plan while working, 30 | | | | 40% less capital to provide for yourself in |
| cents came from investment returns generated | | | | retirement using risk pooling than you would |
| prior to retirement, and a full 60 cents came | | | | structuring an investment portfolio on your own, |
| from investment returns generated after | | | | according to a study by David F. Babbel and Craig |
| retirement. "The pool of assets is so much bigger | | | | B. Merrill of the Wharton Financial Institutions |
| after retirement," says Bob Collie, director of | | | | Center, co-sponsored by New York Life. |
| investment strategy for Russell. Post-retirement | | | | Annuity companies have introduced cash refund |
| investment returns account for an outsize portion | | | | options that have increased their products' |
| of each dollar withdrawn from a defined | | | | popularity. This popular feature insures that |
| contribution plan simply because the asset pool is | | | | investors' heirs will receive money back after |
| larger in retirement, and because people's longer | | | | they die, yet it eats into the benefits of risk |
| lives are putting their money to work over longer | | | | pooling. A 65-year-old male would receive 8% less |
| horizons than before. | | | | income and a 75-year-old man 13% less from an |
| Today's long life expectancies mean that an | | | | immediate annuity with a cash refund than he |
| overly conservative asset allocation won't go the | | | | would from one without, says Mike Gallo, senior |
| distance for most retirees. Indeed, advisors | | | | vice president for retirement income at New |
| recognize that only their wealthiest clients can | | | | York Life. |
| derive a secure retirement from, say, bond | | | | Another approach is to deconstruct the traditional |
| ladders. "You can't do it with bonds alone, because | | | | annuity by layering a low-cost insurance guarantee |
| that would erode the assets," says Thyra | | | | on top of a separately managed account. In |
| Zerhusen, manager of the $1 billion Aston | | | | March, Pershing LLC launched such a hybrid |
| Optimum Mid Cap Fund and of a New York-based | | | | retirement income product, which pairs a |
| foundation's portfolio, which she declined to name | | | | managed account solution with a lifetime income |
| and which she runs the same way as her mutual | | | | guarantee offered by The Phoenix Companies. |
| fund. When Zerhusen began managing the | | | | The product, known as Lockwood Investment |
| foundation's portfolio, it had roughly 70% of its | | | | Strategies Longevity Income Solutions, or LIS2 |
| assets in bonds and the rest in stocks. This | | | | for short, will ensure that investors won't outlive |
| breakdown mirrors the traditional retirement | | | | their assets, says Len Reinhart, the former |
| portfolio. But longer life expectancies, lower bond | | | | president of Lockwood who worked on the |
| yields and a potentially stagnating stock market | | | | product design and now consults for Pershing |
| have zapped the effectiveness of this allocation. | | | | Managed Account Solutions. |
| Zerhusen persuaded the foundation's finance | | | | LIS2 features a 5% annual payout, after fees, |
| committee to adopt the inverse allocation, and | | | | which begins when an investor is 65 years old. |
| today the portfolio is roughly 70% stocks and | | | | The 5% rate is applied to the initial investment for |
| 30% high-quality bonds. | | | | a fixed dollar amount that stays the same each |
| Alpha Alternatives | | | | year. For example, an investor who puts $1 million |
| The foundation portfolio Zerhusen manages is | | | | into the product would get $50,000 each year for |
| unusual in that it doesn't have an allocation to | | | | the rest of his or her life. The Phoenix Companies |
| alternative investments. "We only buy what we | | | | buys 10-year puts as hedges for the guarantee, |
| understand," Zerhusen says. Her expertise in | | | | which assures consumers of their fixed payout |
| identifying undervalued and misunderstood mid-cap | | | | regardless of the underlying funds' performance. |
| stocks has helped the foundation meet its annual | | | | This structure will ensure that investors don't |
| operating goals, which involve withdrawals of 8% | | | | become too conservatively invested in |
| to 10% per year, without sacrificing principal. | | | | retirement, Reinhart says. "The whole point is for |
| Most large foundations and endowments | | | | the client to be in an aggressive growth strategy," |
| (foundations are mandated to give away a | | | | he says. In other words, ensured of a guaranteed |
| minimum of 5% of their assets per year, while | | | | income stream through LIS2, retirees can invest |
| endowments are not) have at least a quarter of | | | | the rest of their portfolios more aggressively. This |
| their assets in investments outside of traditional, | | | | argument is frequently applied to annuities as well. |
| long-only publicly traded equities and bonds, Siegel | | | | Another major difference between retirees and |
| says. "Alternative investments are, in principle, a | | | | foundations lies in their tax treatment. Private |
| more efficient way of generating alpha (if the | | | | foundations pay an excise tax of 1% to 2% on |
| manager has skill) than traditional, long-only | | | | investment income and realized capitalized gains, |
| investments," he writes in an email message. "This | | | | and endowments pay nothing. Needless to say, |
| is because short selling, the ability to leverage and | | | | individuals don't enjoy such favorable treatment at |
| use derivatives, the ability to lock up funds for | | | | the hands of the Internal Revenue Service. |
| long periods of time, and other features of | | | | Furthermore, many retirement income strategies |
| alternatives each contribute in various ways to | | | | are not designed for their tax efficiency. For |
| portfolio efficiency (the expected return per unit | | | | example, investors in Vanguard's Managed Payout |
| of risk taken)." | | | | Funds receive a 1099 tax form each year stating |
| The Harvard and Yale endowments have about | | | | how their monthly payments were generated for |
| 50% of their portfolios in alternatives such as | | | | the previous year, whether by a combination of |
| private equity, hedge funds, real estate and | | | | income, capital gains or a return of capital. This |
| commodities, according to Frontier Capital | | | | complex tax treatment means investors would |
| Management, a Boston-based investment | | | | benefit from holding these funds in a |
| management firm. At $34.6 billion and $22.5 billion, | | | | tax-advantaged account. If Lockwood's LIS2 |
| respectively (as of the end of fiscal year 2007), | | | | product is able to generate income payments |
| Harvard and Yale's endowments could weather | | | | through income or capital gains, then investors will |
| any liquidity challenges that this high alternative | | | | be taxed at the 15% capital gains rate, Reinhart |
| allocation presents. But less-capitalized funds and | | | | says. But if the account balance plunges and the |
| private foundations without access to new money | | | | insurance company must make the payments, |
| from alumni or other contributors (and whose | | | | the investor will be taxed at regular income rates. |
| circumstances are more analagous to those of | | | | Investors who open an IRA account managed by |
| retirees) could face trouble in a bear market if | | | | Lockwood Capital Management and hold the LIS2 |
| they allocate such a high percentage to | | | | offering inside it would enjoy tax-deferred |
| alternatives, Siegel says. Margin calls or forward | | | | treatment on the income. |
| commitments on private equity can force the | | | | Advisors at Greenbaum and Orecchio actively |
| selling of assets, and there are fewer liquid assets | | | | work to minimize their clients' tax burdens. If a |
| to choose from if a large chunk of the portfolio is | | | | client needs income, the firm uses iRebal |
| in real assets. Similarly, your clients will have less | | | | rebalancing software to quickly determine how to |
| flexibility in their income withdrawals if they have | | | | use principal, income and rebalancing proceeds to |
| too much allocated to real assets. | | | | generate the income in the most tax-efficient |
| Some advisors have embraced the use of | | | | way, Plechner says. Clients with more than $1.5 |
| alternatives. "In portfolio design, the ultimate goal | | | | million to invest may choose the firm's ETF and |
| is to have investments that are not correlated," | | | | mutual fund-based alternative investment |
| says Greg Plechner, principal and senior wealth | | | | strategy for tax purposes, he notes. Clients with |
| manager at Greenbaum and Orecchio, a fee-only | | | | alternative investments including hedge funds, |
| advisory firm in Old Tappan, N.J. "With alternative | | | | private equity, venture capital and real estate |
| investments, you're able to attain that." | | | | receive a K-1 tax form that state the investor's |
| Greenbaum and Orecchio allocates an average of | | | | share of the partnership's taxable income. The |
| between 15% and 20% of their clients' portfolios | | | | forms often come late, requiring clients to file an |
| to alternatives. Retired clients have a slightly | | | | extension on their taxes, Plechner says, a hassle |
| smaller allocation to alternative investments, he | | | | some wish to avoid. |
| notes, since their fixed-income portion is higher. | | | | Despite the most careful planning, many |
| The firm's clients with more than $1.5 million to | | | | institutions and individuals will fail to meet their |
| invest have access to private investment | | | | income goals at some point. Following a year of |
| partnerships, while those with less than $1.5 million | | | | poor returns, a foundation can simply cut the size |
| can access similar strategies through | | | | of its grants. Your clients' bills, however, won't |
| exchange-traded funds and notes, and institutional | | | | disappear in a bear market. When clients fail to |
| share mutual funds. For example, the firm uses | | | | meet their income goals, they can cut their |
| PIMCO CommodityRealReturn Institutional, | | | | spending or increase their equity allocation, says |
| Vanguard Energy ETF, and Rydex Managed | | | | Deena Katz, chairman of Evensky & Katz in |
| Futures Fund for market-neutral exposure. | | | | Coral Gables, Fla. The choice, as her partner |
| Choosing private equity and hedge fund | | | | Harold Evensky puts it, is clear: "Do you want to |
| opportunities requires considerably more due | | | | eat less well, or sleep less well at night? |
| diligence than does selecting investments sold on | | | | |