Of course a simple solution would be to let the boomers fend for themselves, and be responsible for all the costs of their own lives, as is done in the majority of the world. Obviously that solution would not sit very well with the boomers themselves, nor would it sit well with the majority of the population. However, the more that boomers fend for themselves, the better off all of society will be. This has been the driving force of academic research and product manufacturing for today’s retirees, most of which has revolved around sustainable lifetime income or products offering to pay a higher yield than easily available to the public. These products have led to government regulations placing limits on the aggressive salesforce of broker dealers and insurance companies who are, at least in the current DOL’s opinion, skimming too much off the top for themselves. Their solution, which takes effect on April 10th, is to minimize conflicts of interest through disclosure and assumption of liability for the distributors of retirement products.
My concern goes well beyond that of regulation. My concern has to do with the lack of portfolio management skills of those financial advisors who the current and future retirees rely upon. The majority of these advisors have lived in an isolated world of product distribution whose portfolio management skills revolved around a suitability standard. My concern has to do with the current academic research that is attempting to find certainty where no certainty exists. My concern has to do with a government that believes all that is needed to improve portfolio management skills can be accomplished by filling out a bunch of paperwork that protects the distributors more than current and future retirees.
I am afraid that these new rules will have little impact in the short run on solving the long-term problems facing retirees and their children. Over time, as the courts interpret and apply the rules of fiduciary standards under the DOL regulations, the financial industry will evolve and produce a better outcome. Until that time, I thought I might help by sharing an article with you written in 1979, towards the end of the last bear market in bonds. There are very few of us in finance today, including academics, government employees and financial advisors, who were actively working with individual investors to build and manage portfolios 38 years ago. Given that we are near, if not already at the end of, the great bull market in fixed income investments, revisiting 1979 may help each of us as we make decisions about our own portfolios.
The article was penned by John Train, one of my favorite authors. His book, The Money Masters, published in 1980, is still on my shelf and is still used for support when I am faced with a difficult decision. The article below, titled “The Trustees Dilemma,” appeared in the July 9th, 1979 edition of Forbes Magazine. With a lot of charm, Mr. Train shares a story of one woman, her family, and the difficulty of applying proper fiduciary management to her trust account. He ends the piece with a call for help from other professionals, as “it’s a problem that requires airing.”
A widow was left a substantial amount of money by her husband when he died. The income went to her for life, with the capital to be divided among their three children after her death.
Her late husband had been a successful New York businessman, and the family had two large houses: one in Greenwich, Conn. and one on Cape Cod, where they went in summer. The children liked coming to the Greenwich place on the weekends and spending long periods on Cape Cod in summer, so she kept both. As a result, the widow found herself living at the limit of her resources.
At her annual meetings with her trustees, the problem was aired frankly. How could she maintain the houses and keep up roughly the same standard of living as before, with her husband’s considerable salary no longer available? Each year it was decided to sell some growth stocks with low yields and move into bonds or high-yielding equities to maintain the needed income, and hope that all would end well.
So the trust portfolio eventually became roughly half fixed-income securities and half high-dividend stocks, notably utilities and the like.
Unfortunately, however, the investment objective was impossible on its face. At a time when costs are rising 10% a year, income has to rise 12% to 15%, as the tax bracket rises, in order to stay even in real terms.
Now, very few income stocks increase their dividends at anything like 15% a year; and, of course, bond payments don’t increase at all.
After some ten years of princely existence, the widow’s buying power in real terms was about 40% of what it had been just after her husband died. The old trustees, friends of her husband, stepped down, and new ones with a more austere and realistic attitude came in. They were dismayed at what they saw. She had to sell both her houses and move into a smaller one, where it was a strain to have any of her children for weekends, since they now had families of their own and come in groups of four or five.
She has many years of life ahead of her, which she will spend in straitened circumstances. If she had cut back right away and adopted a realistic investment policy, she could have been comfortable for her lifetime.
Furthermore, in the future, when the grandchildren come into the inheritance, they will have a justifiable complaint against the old trustees, if they’re still around. They can’t make out a case at law, but it seems to me that they can certainly make one in common sense and morality. By investing flat out for income at a time of hyperinflation, the trustees knowingly dissipated the corpus of the testator’s estate, and thus did violence to his stated wishes and gypped the remaindermen. When the grandchildren ask what happened to their inheritance, their elders will have to explain that it was essentially blown on high living. In fact, the widow herself also has a valid complaint. The original trustees, old business friends of her husband, were paid to give her the benefit of their realism and experience. Why didn’t they look ahead and set her on a sustainable course?
This quandary afflicts most trustees of generation-skipping trusts today. I observe that many trusts are now invested about half in equities and half in fixed-income instruments, with the income beneficiary consuming the distributions from both sections of the trust.
However, in real terms, the bond income these days is simply a return of capital: The buying power of the bond is declining at much the same rate the interest is being paid out (faster, for municipals).
The “rule of 72” tells you how fast money doubles at compound interest. It’s the interest rate divided into 72.
But the rule also works in reverse. Money loses half its real value in the number of years that the inflation rate goes into 72. Thus, in a time of 10% inflation the half-life of money is seven years. So in 20 years of 10% inflation, the bonds in a portfolio may well have been cut in half three times, or be worth in real terms one-eighth of what they were at the outset. In other words, the bond component will essentially be all gone.
What, in this situation, is the prudent and ethical thing for the trustees to do?
There seem to be two reasonable procedures for a trust to follow: (1) Hold some Treasury bills or similar instruments as a reserve, but wait for a good buying point to put most of the portfolio in solid stocks whose income will rise at least as fast as inflation; or (2) If a lot of the portfolio is in bonds, don’t distribute all the income. Alternatively, if there are a lot of bonds, buy some stocks with strong growth but little or no income, such as Crown Cork, Capital Cities, American International Group, Schlumberger or Tektronix, to offset the illusory income from the bond portfolio.
At the moment, good stocks with inflation-resistant characteristics can be bought to yield roughly 4% to 5%. That, therefore, is the maximum that can ordinarily be distributed from any trust to an income beneficiary, if capital is to be preserved.
To get an income beneficiary with limited means used to living on a return of 7% to 8% would seem to me to be a grave mistake, and is likely to be disastrous in the end.
In discussing with clients how much they can live on, I have to explain that if their life expectancy is 20 years or more, they cannot logically hold bonds unless they reinvest all the income, and even then they will be unable to maintain the real value of the capital.
I would appreciate comments from professional trustees on this issue. It’s a problem that requires airing.
The suitability standard practiced by the vast majority of financial advisors is similar. Advisors obtain their A’s by giving the client what they want today, without thinking and without questioning. When John Train discusses the original trustees’ investment approach he says, “They can’t make out a case at law.” He means that if an advisor adheres to the law, meaning gives the client what is suitable for her needs, an advisor or agent will not be reprimanded. But the rest of his sentence shows us that a fiduciary should go beyond the legal limits: “…but it seems to me that they can certainly make one in common sense and morality.”
None of us know how the future will unfold. It is because of this fact that a primary duty of all fiduciary advisors should be to construct a portfolio that helps with the needs of clients today, but allows for enough change to meet the needs of clients tomorrow, no matter what they are.
For today, that means to remember that inflation over the past twelve months was 2.1%. For a taxpayer in the 28% tax bracket, the minimum earnings needed to maintain buying power in the short run is 2.92% before any spending takes place. It seems to me that investing in bonds, or for that matter buying an income annuity whose payment is fixed and based on today’s rates of interest, will have the same effect on the long-term welfare of retirees as John Train’s widow experienced fifty years ago.
Mr. Train ended, “I would appreciate comments from professional trustees on this issue. It’s a problem that requires airing.” So would I.
Until next time,
Kendall J. Anderson, CFA