Broker Check


The Double Dipping Investor

| March 24, 2015
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As I’ve mentioned in previous posts, I have four kids.  For those without children who may be rolling their eyes about the subject, I’d appreciate some slack because I can’t help it.  These people have me surrounded (literally) and they dominate my household!  People joke about the transition from two to three kids requiring ‘zone defense’, and this is true.  Another truth is that going from three to four means that you have gone from living with a ‘pack’ to living with a ‘gang’, at least in my experience.  That said, my kids are big time double-dippers, literally and figuratively.  When we go out for Mexican food, double and triple dipping in the queso or guacamole is standard practice.  The kids went to a birthday party and gorged themselves on cake and juice.  Two hours later they didn’t touch their dinner but don’t hesitate to start working angles to get some ice cream for dessert.   In life, the double-dip is typically not even possible, and if it is, it’s often times frowned upon and viewed as unfair.  Do investors attempt the double dip?  You bet they do.  In a perfect world, investors would love to have their cake and eat it too.  How so?  How about 10% return per year guaranteed?  Sound good to you?  Of course it does.  Unfortunately, it just doesn’t work that way.  As a ‘best practice’, please run from anyone who tells you anything different.

My office was recently the scene of an attempted double-dipping when a very friendly, well-meaning, prospective client came in for a meeting.  Here are the basics of this investor’s case:

·       He is 60, married, and would like to retire at age 70.    

·       He sold all of his investments during the financial crisis and has been sitting in cash ever since.  Naturally, he has a ‘conservative’ risk tolerance.

·       His expenses are projected to be $10,000/month (today’s dollars) in retirement.

·       He currently has an annuity payment of $3,500/month.  He will receive $3,500/month at age 70 from a pension.  He expects social security to also pay him $3,500/month at 70.  Simply put, he expects an income of $10,500/month at retirement.

·       His portfolio (cash) is worth $500,000.

The client asked me if I could provide a ‘substantial’ amount of income from his $500,000 portfolio – ‘substantial’ was never quantified – while at the same time guaranteeing his principle.  After I jokingly pointed out that I felt like I was living inside of one of the many situational “skits” in our mandatory, annual compliance videos, I told him ‘no’.  For the uninitiated, these skits include scenarios such as someone coming in for a meeting and asking if returns are guaranteed (no), or if they can deposit a bag of cash into their account (no), or if a wire transfer from Iran would be an acceptable form of payment (big-time no-no).  I told him that unless he wanted to purchase an investment from an insurance company that provides guarantees – which he said that he does not want to do – there is nothing that I can do to both provide substantial income AND guarantee his principle.  This is an unattainable double-dip.  I told him that in order to provide substantial income from his portfolio it would necessitate taking substantial risk with his principle.  You know, the whole risk/reward thing?   You can’t have it both ways.  Anyway, while he wasn’t overly-enthusiastic about my answer, he did understand what I was saying and he left the office.  He hinted that he will continue with is current investment strategy, which is to do nothing.  He will likely keep his $500,000 in cash until he retires.

What’s wrong with this strategy of holding cash?  This person’s current expenses are approximately $10,000/month.  At 3% inflation, those expenses will naturally grow to $13,439/month by the time he is retiring at 70, and will be $24,272/month at his age 90.  This inflated age 70 retirement expense figure represents a $2,939/month ($35,268/year) gap between his projected income and his expenses.  If this person leaves his $500,000 in cash for the next ten years and earns 1%/year he would have $552,311 in his portfolio at age 70.  The annual income/expense gap that we identified above ($35,268) represents a required 6.4% yield/return in year 1 of his retirement based off a $552,311 balance.  Investors tend to become more conservative as they age, not the other way around, so I don’t really see this happening.  Long story short, this person has a big problem.  What’s the solution?  This client either needs to cut their assumed retirement lifestyle or assume SOME level of risk above an FDIC insured cash account to help close this projected income/expense gap.

I asked this investor to look at this from a new and different perspective.  Investors such as this one who have significant sources of fixed/guaranteed income in many cases can and should be assuming more risk with their investment portfolio assets, especially for inflation hedging purposes.  It’s all a matter of how you view your portfolio assets versus your income streams.   Let’s assume for a moment that we treat his income streams as a ‘bond’ and his current portfolio as cash.

To start, this investor’s expected annual income at age 70 is $126,000.  Please note, this figure is an income and does not represent an actual asset as it is derived from an existing annuity payout, social security, and a pension stream.  That doesn’t mean that we can’t view the income stream as an asset to gain a different perspective.  And if we wanted to see what kind of a hypothetical bond portfolio would/could generate that type of a fixed income, we could figure that out quite easily.  At a hypothetical bond/fixed income-like yield of 4%, this would imply that a fictitious bond portfolio of $3,125,000 would generate a fixed income of $126,000/year ($126,000/.04).  If this client did in fact have the $552,311 in cash that we assumed above at retirement age (holding his $500,000 portfolio in cash at a 1%/year return), this would represent a theoretical allocation of:

·       85% Bonds/Fixed Income ($3,125,000)

·       15% Cash ($552,311)

When you look at it in this context, this theoretical allocation is clearly quite conservative and as we’ve discussed, is likely to not get the job done.  In fact, given our inflation assumptions above, the situation (income/expense gap) will deteriorate further each and every year of his retirement as his purchasing power withers because prices rise and his income cannot keep up.  How might he improve this situation?  I suggest that although his risk tolerance is low, allocating the majority of his $500,000 portfolio to equities/stocks isn’t all that outlandish, especially given a 10 year time horizon.  If this 85/15 (theoretical bond portfolio/cash) allocation was changed to 85% bonds and 15% stocks, that would still be considered conservative by any measure.  In addition, the client is a well-paid professional with significant job/income security, so his chances of needing to withdraw funds from his portfolio over the next ten years is minimal.  Remember that this investor has no equities in his current portfolio and has nothing in the way of an inflation hedge to combat rising costs over time.  Stocks, particularly when held over a 10 year time period can be an effective engine for growth, and therefore an effective solution to this investor’s problem.    

In summary, this all depends on how you quantify risk.  Do you measure risk in a traditional sense using a portfolio’s volatility (standard deviation), or by the risk that you’re either out of money or have to dramatically lower your lifestyle in retirement?  It depends on the investor, but as it stands, this investor needs to essentially ‘pick his poison’.  Does he choose volatility in the near term with a higher likelihood of success in the future (purchase equities), or the soothing, near term comfort of cash with the certainty of a disappointing retirement (at least financially).  At the very least I hope that this investor feels better knowing that he does have options.  Taking into account portfolio assets AND fixed income streams can help to drive investment strategies that you have never considered.

The conclusion?  While double dipping is possible at your local Mexican restaurant, it’s almost never possible with your portfolio.  Save it for the queso!

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price. There is no assurance that the techniques and strategies discussed will yield positive outcomes. 

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