In 2005, successful do-it-yourself investor Les Hickok and his wife hired a financial planner to manage the portfolio they'd amassed. Planner Derek Kennedy, founder and president of Kennedy Wealth Management in Knoxville, Tenn., ran a stress-test on the retirement savings of the duo, who were both in their sixties. The goal: to see how their money would last after a Great Depression-type scenario that featured a 23% hit in one year and 21% slide the year after. "At the time, it seemed a little ridiculous to me," Hickok recalls of the exercise.
It paid off three years later when global markets collapsed. Kennedy called the Hickoks to make sure they weren't panicked by the scary headlines.
Hickok replied that the downturn didn't seem devastating for them, and he told Kennedy he remained confident in the disciplined rebalancing strategy they had in place. "We just don't care and we're ignoring it," Hickok said.
It's what every planner wants - bullet-proof retirement strategies for clients who can then remain calm through the worst volatility. The methods advisors are using to build a financial fortress vary widely. Some advisors around the country say they are finding unusual and, in some cases, exciting new opportunities to banish uncertainty from their clients' retirement strategies during a time of deep insecurity across global markets.
"Volatility, while it's scary and disconcerting, provides opportunities," says Kim Ip, a partner with responsibilities in investment research and portfolio construction at advisory firm Luminous Capital in Los Angeles. "We actually like it because we've been able to buy things we wouldn't have been able to buy otherwise."
Growing a portfolio through opportunistic investing is redefining retirement planning. When the government started Social Security in 1935, Americans on average were living just a few years past their retirement. Today, retirement savings must last - and perform - for decades. "Retirement isn't an event. It's a process,'' says Kurt Brouwer, a planner and co-founder of Brouwer & Janachowski in Tiburon, Calif. "One person in a couple may be alive 25 years after retiring. So if you don't have some growth in your portfolio, taking into account inflation and other factors, then you could really be struggling 25 years from now."
Guaranteed income, without sufficient growth won't cut it, Kennedy says. Two decades later, "that income is not going to be worth as much and you won't have as much buying power. The threat of inflation over time is just as large as that of volatility," he says. "You need return."
The drive for return is taking advisors into undervalued mortgage-backed securities, international debt and master limited partnerships that own real assets, including oil and gas infrastructure. Annuities, Roth IRA conversions, ETFs and even farm land, along with more classic investment strategies, can all play a role in boosting growth. "In this market,'' Ip says, "you have to be opportunistic."
UNLOVED MUTUAL FUNDS
Every market has excellent fund managers focused on asset classes that have fallen out of vogue. For the past several years, Brouwer has made the hunt for those funds a focus of his practice.
"At any given point in time there are consensus ideas that are considered no-brainers,'' he says. "In 1999, it was tech stocks. In 2006, it was real estate. Now it would maybe be gold. It's dangerous to go where the crowd has already gone."
Brouwer now likes underappreciated growth mutual funds that have suffered in the flight to bonds and other fixed-income securities. "At some point, interest rates will start going up," Brouwer says, "and people will want to get out of bond funds and the trend may turn around."
Brouwer says he is mimicking the behavior of some large mutual fund companies that routinely take assets away from funds with winning managers and direct them into funds that haven't performed as well, but may be positioned to do so later. In 2010, Brouwer began investing in funds that contained mortgage-backed securities during a time when people were still calling the entire asset class "toxic."
"By definition," he says, "the recent past won't be that great" for these funds. "That's when you find things pretty cheap."
INVESTING IN THE LAND
Luminous Capital, which caters to high-net-worth clients with $10 million and more in investable assets, recently began pursuing a novel strategy to generate growth. The firm has allocated $80 million to a limited partnership that owns about 30 crop farms, Ip says.
Because farming can be volatile, wise investors select the right plots of land that use new management and production practices. "They try to buy farms that fundamentally have really good soil and really good water rights," Ip says. "They install irrigation, do precision leveling to optimize yields."
With improvements like this, and several agronomists on staff, the partnership is helping farmers adopt best practices to boost productivity using new high-tech tools. "It's a real symbiotic relationship," she says.
The strategy hinges on investing in high-quality farmland for less than the price paid by institutional investors, who are buying agricultural land in Idaho, Illinois, Indiana and Iowa.
"People don't realize there are farms with just as high crop yields for much less money elsewhere," Ip says. She figures the window for this buying opportunity won't be open for long.
The partnership is throwing off a 5% annual cash yield before fees. Ip anticipates its internal rate of return will run between 8% and 12%.
In a year when some clients may face significant losses from sole proprietorships or take write-offs from charitable donations, it may be time to deploy Roth IRA conversions to generate tax-free income for later retirement years, says Tom Bullitt, who runs Mill Street Investment Management, a division of Ballentine Partners, in Waltham, Mass. One of Bullitt's clients runs a sole proprietorship that was incurring losses two years ago.
"We did a Roth conversion because you could take income from an IRA and it would be offset," Bullitt says. "Given that we are managing money using very tax-efficient securities, some of our clients have very low taxable income. We can engineer the amount to be converted to a Roth so that the money comes out at a 15% tax rate. It's a tax-efficient way to manage their financial situation."
Roth conversions can also be timed to coincide with large charitable gifts. "Sometimes a client has a multiyear charitable commitment," Bullitt says. If it's $25,000 annually for a total amount of $125,000, for example, Bullitt has recommended that the client make the donation all at once to clear the way for a Roth conversion in that same year. "You want to recognize income in the same year that you take the deduction," he says, "so there's a case to be made for accelerating contributions and accelerating withdrawals from your IRA."
The size of the mutual fund market, with nearly 12,000 funds, vastly outnumbers that of ETFs, with about 1,400 in the U.S. But that gap looks likely to shrink in this still-new era of market volatility and low yields.
Many planners say they prefer ETFs to mutual funds because of their low fees and their tax efficiencies, as well as the ability to sell in and out of them more easily during periods of volatility - a key factor in keeping a retirement portfolio intact during a fast-moving market slide.
During times of low volatility, the key differences between mutual funds and ETFs hasn't meant as much as it does lately. "With an ETF," notes Kennedy, "you can pick the moment to sell and make it as seamless and as instantaneous as possible."
As planner Sandra Field, founder and CEO of Asset Planning in Cypress, Calif., puts it: "If the market was dropping 600 points, I can sell right now. I'm out and I'm into cash. With a mutual fund, I have to wait until 1 p.m. [Pacific time]." Some funds require sales many hours earlier, and selling mutual fund shares can take as long as three days from the time an order is placed.
ETFs are a central part of Kennedy's modern portfolio management strategy. He routinely sells off winners and buys lower-priced holdings in counter-balanced securities. That way, he avoids the risks inherent when trying to time the markets. To save money, he tries to buy ETFs from FocusShares, which charges no commissions when purchased through Scottrade, which is his custodian.
"A lot of my clients hear about the concept of rebalancing from me for the first time," Kennedy says. "Most of my retired clients who were with me [during the 2008 downturn] are back to being whole again, as if it never happened. Even the markets aren't back to where they were."
GROWTH THROUGH ANNUITIES
"Immediate annuities are a perfect flip on life insurance policies," says Steve Williams, director of U.S. financial planning strategy for Chicago-based BMO Harris Bank, a subsidiary of Bank of Montreal. Instead of giving an insurer a monthly payment in exchange for a single large payout when policyholders die, investors pay a onetime lump sum in exchange for reliable monthly payment for the rest of their lives. "We find it particularly appealing for someone in the 65- to 70-year range," Williams says.
Traditional retirement planning, Williams says, comprises three legs on a stool: Social Security income, pension income and proceeds from savings.
"A couple of those have really been shortened or done away with altogether," Williams notes. "Much pension income disappeared and Social Security has been reduced and, so, the predictable stream in retirement has greatly been reduced."
For that reason, Williams likes immediate annuities despite their relatively high costs. He's not alone. Sales of immediate annuities grew 3% in the first three quarters of 2011 over the same period in 2010, according to Judith Alexander, director of sales and marketing at Beacon Research, which collects data on the insurance industry.
That doesn't sound like much, but Alexander says the jump is remarkable given that rates have been dropping, which means the monthly annuity payments have shrunk. The increased sales of immediate annuities is likely due to their rising use as pension-replacement tools and the growing number of baby boomers entering retirement, she adds.
Field says it's critical that investors understand when and how to use annuities and the differences between annuity classes. One of her clients decided to put more than $2.5 million into a tax-deferred annuity with a five-year contract before he began working with her.
Field describes him as a savvy executive with an annual income of more than $600,000. The client believed, based on the insurance company's sales pitch, that he could invest in it as if it were a CD. He anticipated making a 2.8% return, more than a bank account would have earned.
"Oh, nay, nay, nay," Field says she had to explain to him. Taking the proceeds at the end of those three years exposed him to such high tax rates given his already high tax bracket that his after-tax gain was about 1.4%, about what he could have earned in a CD.
"When I pointed this all out, he said, 'Why didn't they explain all this to us?'" Field recalls. "I said, 'They just don't.'"
"I'm not anti-annuities," the planner hastens to add. "I'm just anti-annuity without education.
BEWARE OF FUTURES
Some planners are using managed futures, an investment that has been getting much attention lately. Many advisors, though, caution that they are complex and carry heavy tax burdens. An investment with the world "futures" in it comes with a K1, Field notes. "And your investor will not be happy with you. That's a huge imposition at tax time for the CPA to fill out."
She learned that the hard way. Recently, Field believed she had made a great investment in the PowerShares DB US Dollar Bullish Fund (UUP), betting that the dollar would strengthen against foreign currencies. It didn't end up mattering that she was right.
"It looks like a normal ETF," says Field, who thought the managers were doing actual currency trading. The fund turned out to be made entirely of contracts. "It doesn't say 'beware.' We did these trades. We hopped in, made some money and hopped out and - oh, darn!"
The tax burden generated by the contracts outweighed the gains that were reaped, Field says. "That was my mistake," she says, adding that when she shared her experience in her study group composed of other top planners in the area, no one knew about this particular trap either. "So I didn't feel quite so dumb."
Brouwer says he and the members of his team have looked at futures for years, but they haven't used them because of their complexity. "They have some particular benefits in that they are not correlated with the other markets very closely," he says, "but there haven't been many liquid ways of investing in that world. It can be hard to understand them and they are often fairly expensive in terms of overall cost structure. We've looked at them and looked at them and haven't pulled the trigger."
Field says she's also discovered that in the post-Madoff era her errors and omissions insurance policy doesn't cover investments containing futures or futures contracts. Insurers, she says, "want everything plain vanilla. Thank you, Bernie Madoff."
CASH FLOW IS KING
These days, plain-vanilla investments must perform with vigor to win over planners. It's pay to play," says Field, that rare planner who reserves part of many days to trade in her clients' portfolios, a task she relishes.
Most investments don't make the cut unless they throw off serious income, she says. Since the downturn, Field has completely changed her investment orientation toward income, with an eye to tax efficiencies and growth with very few growth stocks. She has set up many clients with monthly cash deposits to their bank accounts from their investment accounts to mimic payments they might otherwise be getting from pension plans.
"It's pretty horrible to go through a year of volatility and end up flat," says Field, who says she's determined not to let that happen to her clients. "Stocks pay dividends four times a year, bonds pay interest two times a year. I need a 4.5% to 6% return so that when we have exposure to the market, it gives us that extra boost when the market is running like it is now."
The era is over for set-it-and-forget-it retirement plans. Nowadays, it takes enterprise, innovation and constant review to create strategies that offer growth in volatile times.
Ann Marsh is a senior editor and the West Coast bureau chief of Financial Planning.