Many of today's retirees lived through the Great Depression. Some of them may have felt like they were returning to the bad old days when last October's fears about a financial system meltdown helped touch off the worst drop in the Dow Jones Industrial Average in 21 years. Despite the federal government's $700 billion bailout plan, the crisis continued to spread. Almost nothing in the global markets was moving up. Almost being the operative word.

"The only thing that goes up when the markets are really bad is correlation," says Matthew MacEachern, portfolio manager for Emerald Asset Advisors in Weston, Fla.

Or, to put it another way: "Everything went down. The bonds went down, the stocks went down, the dollar went down," says John Kroll, managing partner of HKP Financial, a registered investment advisory firm in Miami Lakes, Fla. "We threw everything out the window."

Even today, though the market has bounced back from its nadir, we're still nearly 35% off the market's historic high two years ago. For people at or near retirement who have their savings in a conservative-to-moderate portfolio, the market downturn has proven especially troubling. Where in the past one might expect a downside of 5% to 6%, the downside with a conservative portfolio last year could have been near 18% to 20% because bonds did't offset equity losses with gains, Kroll observes.

"The bonds weren't doing their job," he says. "That has really made me reconsider my strategies."

The global economic recession has no doubt caused many advisors to reconsider their investment strategies as they try to maintain and grow their clients' retirement income in the face of a nearly unprecedented downturn, coupled with the uncertainty about the strength and duration of the recovery. Most have tinkered with asset allocations. Others have incorporated annuities into their portfolios. Some advisors, meanwhile, have become even more creative and abandoned modern portfolio theory (MPT) altogether-at least for the time being.

NO PLACE TO HIDE

The move by some advisors away from the venerable modern portfolio theory is not really a rejection of Harry Markowitz's efficient frontier; it is a recognition of its limitations. Markowitz's landmark 1952 paper argued that a portfolio should be diversified across asset classes that are not well correlated in order to reduce the overall risk of the investments. Diversification has been the cornerstone of portfolio construction for financial planners ever since.

The limitations of MPT, however, have been brought to the forefront during the global recession. Namely, the market disruption spread across all asset classes, essentially rendering the diversification strategy futile for a time. Or rather, as Kroll says, "everything went down."

Morningstar highlighted this shortfall in a November 2008 report: While investment-grade bonds turned in stellar returns between 8% and 11% when the stock market plunged from 2000 through 2002, bond funds struggled in 2008. For retirees, the losses were stressful, and in many cases forced people to return to the workplace. "High-quality bond investing is not the retirement savior it used to be, and that's really the driver behind why so many advisors and their clients are in search of a different solution," says Medon Michaelides, managing partner of Emerald Allocation Strategies, which markets separately managed accounts from Emerald Asset Advisors.

NEW EFFICIENT FRONTIER

Of course the basic tenet of MPT—lowering portfolio risk through diversification—remains such a deeply ingrained element of financial planning that many advisors are looking for new solutions that still closely follow this framework. But Peng Chen, president and chief investment officer of Ibbotson Associates, has sought to improve on one of the key components—the mean variance efficient frontier (MVO). Portfolios lying along the efficient frontier curve have the highest expected return for the given amount of risk, while portfolios below the curve are considered inefficient for taking on too much risk with too little expected return.

Chen, however, believes the MVO model is flawed. The main shortcoming, he says, is its focus on a portfolio's risk-return tradeoff in terms of returns, rather than considering the risk-return tradeoff of a portfolio's ability to generate sustainable income.

"It's all in return terms—in percentages and so forth," Chen says. "It doesn't necessarily translate to the income and how much it is or how long it lasts."

He notes that people have traditionally been more focused on returns because most of their money had been managed by defined benefit plans that convert a lump sum into a basic income stream. Because this income stream lasts for as long as a person lives, there was no need for investors to think about interest rate implications and how they impact the trade-off across different asset classes.