Why Bond Portfolios are a Flawed Retirement Strategy

This post is a summary of a session from the FRA’s 8th Annual Managed Accounts Summit.

There are three phases of life and three phases of investing based on a client’s income needs: Growth Only, Growth and Income and Income Only, according to Michael Jones, Founding Partner, Riverfront Investment Group. For retirees in the Income Only phase, what they really need is a cash flow that grows.

Instead, what the industry has done is use systematic withdrawals and build a growth portfolio with a little lower volatility and then hope that everything will work out, according to Michael. The financial crisis showed a major flaw in this strategy. Suddenly a 6% annual withdrawal became a 9% annual withdrawal due to the drop in valuation. If you’re blowing a hole in your portfolio on year one, it’s really hard to bounce back, he observed.

“What do retirees want?”, Michael asked.  They want a quarterly statement from their asset manager that has the same number on it as it did last quarter.  That’s how they define safety.  What do they need?  Income.

Because of this, Michael pointed out that retirees are scared and they’re running to bonds.  They didn’t want bonds back in 1990 when interest rates were at 9% or in 2000 when they were 7% or in 1984 when they were 14%.   Now we have 2 ½% treasuries and they can’t get enough of them!

According to an article Michael recently published (“The Bond Bubble: Are Your Portfolio’s “Safe” Assets Safe?”), he expects deflation will be avoided and “history suggests that bonds currently offer extremely low potential returns in exchange for a substantial risk of loss. For example, if 10-year Treasury yields rise to 4%, a level seen as recently as April 2010, bond investors are likely to incur a principal loss of approximately 10%.”

In this environment, if we don’t get inflation, bond investors will be hit hard. As Michael explained, while treasuries were overvalued, corporates, mortgages and high yield were so cheap you could get away with buying bonds and make out reasonably well because spreads were so wide. But now, spreads have collapsed and yields on all those asset classes are at all-time lows.

Compared to the returns on a one- year treasury rolled over annually, the dividend yield on the S&P 500 beats it handily over the past 40+ years. In the past 10 years, there’s been a 40% increase in dividend income from the S&P500, even with the financial crisis, Michael reported.

You can potentially get a higher yield from the dividends paid by the stocks in the S&P 500 than from their 10- year bonds. All the growth potential and net dividends you can get for free. More current income, more future income higher short-term volatility, but lower in the long-term.

Why Bother Using an SMA Outsourcer?

This post is a summary of a session from the FRA’s 8th Annual Managed Accounts Summit.

According to a recent report by the Tower Group, the use of “cloud services” will become mainstream by 2015, stated Seth Johnson, CEO & Co-Founder, Redi2 Technologies. They will slowly evolve into public utilities that integrate traditional licensed software, augmented by vendor domain expertise. Cloud services currently represent just 1% ($4 bil) of total IT spending, but are projected to grow to almost 5% ($22 bil) by the end of 2012.  Now, I’m not sure if Seth was referring to total IT spending by Wall Street or overall IT spending.  I found an article referencing a report by IDC that estimates that 15% of IT budgets will be tied to cloud computing in some way by the end of 2011!  This is a big difference but still makes Seth’s point that cloud computing is something you shouldn’t ignore.

What are you seeing by way of industry developments in outsourcing?

SEI has seen more RFPs for SMA outsourcing services in the past 6-8 months than in the previous four or five years, according to Carmine Remo, Managing Director, Head of SMA, SEI.  Specifically, as it relates to the wrap business, he said that models only trends have really cut the number of accounts that investment managers have to take care in their back office.  The trend around models only has really shrunk the manager’s back office and forced them to focus on their core business.  This hasn’t done much to reduce manager’s fixed costs, but has reduced their variable costs a bit, Carmine noted.  One of the key things to look for in outsourcing is the ability to scale both up and down as needed, he advised.

Speaking of scalability, SEI just announced that it has extended its relationship with RiverFront Investment Group, LLC to provide operations outsourcing services for the firm’s separate account business for an additional three years. Riverfront cited the scalability of the SEI platform as one of their deciding factors.

Why Outsource?

Most firms use outsourcing to get access to an expertise that is hard or expensive to maintain on their own, Carmine observed.  For example, fixed income strategies are getting more shelf space and firms lacking fixed income expertise can connect with an outsourcer to provide it for them.  SEI is helping PIMCO launch a municipal bond ladder strategy. (see press release here) “Who’d have thought we’d be seeing a muni bond ladder strategy in an SMA WRAP space?”, Carmine asked.

How can you help investment managers deal with the competitive pressure to reduce their fees?

Joseph DiTalia, Director at Citigroup, questioned whether outsourcing is an efficient, cost-cutting measure?  At Citi, cost is just one component and they don’t focus on it.  “We see it as a way to create value for our clients”, he emphasized.

It’s critical to have a predictive cost model whether your growth is up or down.  And according to recent research, managers consider accuracy as well as cost when looking at an outsourcing provider, Joseph countered.

What are some of the ways that an outsourcer can improve operational efficiencies?

Whether a manager is looking at Citi for outsourcing services in the retail SMA space, wealth management solutions on the distributor side, or institutional middle office services, the bottom line is that they’re really looking for a partnership.  They want to integrate their business with the broader services that an outsourcer can support for them, Joseph asserted.

When you think about some of the things that have been discussed in earlier sessions about data integration, one question keeps coming up, Joseph noted.  What do you do with that data?  How do you provide data in a meaningful way to management and stakeholders?  An outsourcer can provide a suite of services that would normally require a manager to partner with a number of firms and put them together, he said.  The outsourcer handles the integration, the vendor management and the ongoing development of the platform to take more off of the asset manager’s plate.

Long term from a quantitative perspective, one area where Citi is creating value for  managers is the concept of alpha, Joseph explained.  There are different sources of alpha, it’s not solely an aspect of performance.  One additional source of alpha is operational alpha.  Citi will be publishing a white paper that details how efficiencies in investment operations from outsourcing can help managers “capture 150 to 200 basis points in performance improvement for the end client.”  Not only by allowing managers to focus on their core competencies, but by driving areas of enhancement and development that come from using more integrated platform, he argued.