Category: Research

Retirement Income Generation 101

The following is meant to be a quick summary of retirement income strategies. If you are interested in learning more, please contact me or read my longer and more detailed article on this topic.

Introduction to Retirement Income

The stakes are high when it comes to retirement income. Unfortunately, salesmanship and conflicts of interest are rampant in the financial services industry. In most cases, the investment advice you receive will be a direct result of the type of financial professional you speak with (e.g., broker vs advisor vs insurance agent or a combination thereof). The purpose of this post is to help retirees and other investors see through the smoke and mirrors and make informed decisions in the context of generating retirement income.

My goal here is to provide a high-level overview of the primary options available to generate retirement income – not to go into the granular details. I believe the information below should be enough to help you narrow down your choices so you can start exploring and refining the most appropriate options.

Note: This post only discusses retirement income, but it is also important to make sure your plan is tax-efficient and minimize the likelihood or impact of unexpected events that could jeopardize your financial security. One should conduct more comprehensive planning to address these issues.

Executive Summary

Living off dividends and interest: One requires substantial wealth to live off of natural portfolio income and avoid dipping into principal (e.g., 30-50x your annual spending budget in a world with yields around 2-3%).
Safe withdrawal rates: Maintain a balanced portfolio and generate synthetic retirement income by chiseling from the portfolio. This naturally involves high dependence on market performance. Fees can range from low to high (e.g., 0.10% – 2.5% per year) depending on how the strategy is executed.
Annuities: The primary benefit of these products is that they have the ability to guarantee streams of income for as long as you live. Some annuities have excessive fees (e.g., 3-4% per year!) and can result in higher taxes. Unfortunately, big commissions encourage brokers to sell many of the more expensive and tax-inefficient products.
Structured Investment Income (SII): A potentially safer, simpler, and lower-fee hybrid strategy that can maximize retirement income and performance through efficient risk management. Our intuitive Set It and Leave It™ approach targets annual fees of just 0.10% (10 basis points) per year, is incredibly tax-efficient, and requires little, if any, maintenance.

Four Primary Strategies for Retirement Income

Below I identify what I believe are the four primary strategies for investors to use their savings to generate retirement income. Each approach has pros and cons in terms of security, level of income, fees, liquidity, legacy goals (e.g., heirs or charities), etc. Each person naturally has unique perspectives, experiences, preferences, and priorities. So there is no one-size-fits-all answer. However, I suspect the attributes I highlight below can help you narrow down your choices.

Note: I left out the ‘pillowcase’ option whereby one could simply stash their cash in their pillow or bank account and take money out as they need. The math behind this situation is relatively simple (e.g., spending a $100,000 per year for 40 years requires $4 million). However, this approach is still subject to the risks related to inflation and longer than expected longevity (i.e., running out of money) – two specific concerns I address below.

Option #1: Living off dividends and interest

The first option is to buy a portfolio of stocks and bonds and then live off the income they provide – dividends and interest. The goal here is to live off the natural income streams these assets throw off without dipping into the principal. In addition to simplifying one’s income strategy, this can also reduce one’s dependency on market price performance.

Note: In my experience, the stability of dividend income surprises most people. I suspect many assume dividends are volatile because market prices are. However, this is not necessarily the case as I discuss in my Destroying Steady Income article.

The obvious challenge here is having enough wealth to generate the income you need. Given the current low rates of interest and dividends (as of September 2016, dividend and bond yields are in the range of 2-3%), this requires savings on the order of 30-50x your annual spending budget. If your annual expenses are, say, $100,000, then you will need approximately $3-5 million to comfortably rely on dividends and interest without accessing the principal (absent other sources of income).

Real estate?

Of course, real estate and other income-generating investments can work too. Rental yields from real estate, for example, are typically higher (perhaps due to the lack of liquidity, potential headaches involved, or slower growth rates relative to stocks). Real estate transactions typically take weeks or months and involve significant transaction (e.g., closing) costs. Moreover, maintaining a property or dealing with tenants might be too much for many to handle.

Notwithstanding these potential issues, it is possible to find real estate investments generating reliable yields of 4% or higher. Of course, real estate investments can be leveraged to boost the yields even higher (e.g., upper single digits). In this case, the quality of the cash flows generated by the properties is paramount. Whether you own the property yourself or through another party (e.g., manager or fund) with leverage, you do not want to miss an interest payment or your investment could evaporate.

The bottom line: Suffice to say, not many folks fall into the category of being able to live off their dividends and interest alone. However, you need not despair. Option #4 below (Structured Investment Income) provides a blueprint for how to structure a similar solution for income.

Option #2: Safe withdrawal rates (SWR)

Building a balanced portfolio (e.g., 60% stocks and 40% bonds) and chiseling off principal is probably the most popular approach to generating income for retirement. The idea is to estimate how much one can safely withdraw without jeopardizing financial security down the road – hence the safe withdrawal rate (SWR) label.

William Bengen, an MIT rocket scientist who went into financial planning, is credited with the seminal research on the topic of SWR income strategies. He ran historical simulations and illustrated the interplay between portfolio allocations, SWRs, and wealth depletion. He is also credited with coming up with the 4% rule. This rule of thumb suggests investors with balanced portfolios should be able to withdraw 4% of the original balance in the first year and then the same amount adjusted by inflation each year thereafter. In particular, his simulations indicated this strategy very rarely resulted in wealth depletion.

Issues with SWR Strategies

In my view, there are two issues with SWR strategies. The first issue is market dependence. No matter how many simulations or statistical analyses you run, markets may not behave the way they have in the past or how your simulations assume they will. I find this notion to be discomforting since past performance is not necessarily indicative of future performance.

The second issue I identify with SWR strategies relates to the fees. I see many instances where investors are paying investment advisors to execute these strategies. For example, consider a 1% advisor fee and a withdrawal rate around the 4% rule of thumb. You would effectively be sharing a quarter of your retirement with your advisor.

Truth be told, SWR strategies are fairly straightforward to execute once they have been set up. All one has to do is periodically rebalance the portfolio to match the specified allocations and generate the desired income. Indeed, there are now many robo-advisors who do this for low or no cost. This is not to say advisors cannot add value in other ways.

For example, I believe it is important to tactically alter the allocations to reflect different market conditions. Value-adding strategies like this can earn an advisor’s fee many times over. However, this is not the norm for most advisors who employ a reactive rebalancing process based on what markets have already done.

Option #3: Annuities

The above SWR approach clearly involves a significant degree of market risk. Moreover, standard investments are not aware of your lifespan. One way to address these risks is to purchase products which guarantee income as long as you live. We call these products annuities and only insurance companies can sell them (since they are institutions that manage longevity risk). Without doubt, guaranteed income is a highly attractive and desirable feature.

Note: Insurance companies can run into trouble too as many did during the financial crisis. However, they are highly regulated and many states effectively step in to guarantee annuity products if carriers have financial issues. In my view, this makes the risk of defaulting on their guaranteed payments minimal.

Tax Benefits

Another benefit annuity products can offer is tax-deferral. In particular, investments can grow and one can make changes to the underlying portfolios without triggering capital gains. In general, tax-deferral can provide immense benefits. However, the net earnings are ultimately taxed as income tax (which is generally much higher than capital gains rates) when the owner eventually withdraws those funds. This is a significant issue in taxable accounts.

Without doubt, income that is guaranteed to last throughout one’s lifetime and tax-deferral are very desirable in the eyes of risk-averse investors looking to secure their financial well-being. So insurance agents are able to make very compelling marketing pitches. However, it is important to weigh the benefits with the associated costs and constraints.

Some annuities (e.g., variable annuities) have fees as high as 4% or more per year and may involve lockups or surrender periods whereby one cannot sell their annuity for several years without paying significant penalties. Suffice to say, people selling annuities do not always focus on these items.

The bottom line

Annuities are unique in being able to make guarantees related to income and longevity. However, annuity salespeople often like to sell the higher fee products because they get bigger commissions. At the end of the day, you have to work out the math and balance the risks to see how they compare to other income strategies. For example, fixed annuities strip out many of the bells and whistles to isolate the core benefits of lifelong income and tax-deferral. As a result, these products typically have much lower costs than their variable annuity cousins.

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Learn more about annuities

I have had extensive experience analyzing annuities on both the consumer side working with individual investors and (earlier in my career) on behalf of insurance companies looking to hedge their annuity businesses. In my experience, the fees most (but not all) of these products charge outweigh the benefits they provide. These products involve much financial engineering, so the math is often difficult to untangle. However, the basic logic is straightforward.

An insurance company is an intermediary between you and the market. They provide a service (aggregating and hedging risk) which costs them money and then they tack on their profits on top of those costs. They must also educate and incentivize (via commissions) armies of salespeople to sell their products – a costly endeavor to be sure. At the end of the day, all of these costs add up and ultimately come out the pockets of people who purchase these products.

Keep an Eye on Costs

While we do not know the precise costs or profits embedded in many of these products, there is another way to estimate how much of your money goes toward the costs above (and thus how much of your investment is left to work for you). You can simply add up the annual fees over the expected lifetime of the product. For example, if the annual fees are 2.75% and you plan to hold the product for at least 10 years, then you will lose approximately 27.5% (10 x 2.75%) of your original investment to these fees. Just 72.5 cents of each dollar will will be working for you.

The fee example I used above is admittedly on the higher end of the spectrum (but not the highest I have seen!). There are many different types of annuities with varying costs. In general, the fancier products have higher costs and the simpler products have lower costs.

Two Options for Lifelong Income

Now that I have made my views clear about annuity fees (beaten the horse to death?), I will now highlight two different annuity products that guarantee lifelong streams of income. The first is a variable annuity with a guaranteed lifetime withdrawal benefit (GLWB). A variable annuity is effectively a retirement vehicle which invests your money in various funds and allows the earnings to grow tax-deferred (though ordinary income tax applies to the returns when they come out).

When one also purchases the GLWB for the annuity, there is a guaranteed minimum level of annual withdrawals (e.g., 5% of the original investment) as long as they are alive. While the minimum level of withdrawal is guaranteed from day one, this minimum level can also increase (but not decrease) through time if the performance of the portfolio reaches certain hurdle rates. In other words, this product can both guarantee a minimum level of income but also allow for some upside if the underlying portfolio performs well.

In addition to the GLWB, there are many other options (called riders) investors can add to their annuity contracts (for additional fees) – enough to make most heads spin. On balance, the wide array of features, riders, payouts, and embedded costs make variable annuities fairly complex. So I am never surprised when I meet people with variable annuity contracts they do not understand.

The SPIA

Now I will discuss an annuity product which is on the opposite side of the complexity spectrum: the single premium immediate annuity (SPIA). This product simply converts a lump sum of cash investment into a guaranteed lifelong stream of income (e.g., 7% of the original investment). When discussing these products, many folks are quick to ask “What if I get hit by a bus the day after I sign the contract?“. Luckily, there are fairly inexpensive options that can add guarantees relating to the minimum number of years of payments or total amount of payout that is guaranteed.

There are some important distinctions between the two products I have discussed. For example, variable annuities are more complex (hence the multiple paragraphs to describe them versus just one for the SPIA). In terms of income, the guaranteed payouts of the variable annuities with GLWB rider are typically lower than for SPIAs. However, variable products provide potential upside to the guaranteed payments. Moreover, they may also leave some money left over for at the end (i.e., for beneficiaries).

On balance, annuities can offer some attractive features such as guaranteed income and tax-deferral. However, investors must weigh these and other benefits against their costs. This is the only way to figure out which of these products (if any) are suitable for their financial plan.

If you would like to learn more about annuities, please contact me or read my longer article that includes more details.

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Option #4: Structured Investment Income (SII)

This section describes my Structured Investment Income (SII) approach. It is a hybrid of the SWR strategy and annuity products discussed above. This approach targets the primary advantages of both strategies (reliable income, liquidity, and capital growth). However, it also addresses two of their major drawbacks (costs and market dependency). On balance, I believe SII is a much simpler strategy and allows investors to enjoy more peace of mind.

I target total fees and costs around 0.10% per year (i.e., 10bps per year). That is just a fraction of the costs associated with most retirement strategies. Moreover, SII can be significantly more tax-efficient as well. Please contact me to learn more.

As I highlighted above, very few people have enough money to live off interest and dividends. In other words, they will have to dig into principal. This is precisely what happens with annuities and SWR strategies – even if it is not evident. The constant gravity of fees may be subtle and market volatility may obscure the trend. However, principal erosion is a certainty for those who cannot live off the natural income generated by their portfolio.

What is SII?

So what is my SII approach? The easiest way to understand SII is to consider a hypothetical example. Let us say Jane Retiree is 65 years old and has $2 million in savings. Furthermore, she expects to spend $100,000 a year in retirement. So her current spending budget is 5% of her portfolio (=$100k/$2m), but will likely increase with inflation. Unfortunately, 5% is higher than the 2-3% yields on stocks and bonds. Moreover, it is higher than the 4% ‘rule of thumb’ discussed above. In other words, she cannot live off the dividends and interest. Thus, traditional SWR strategies would run a higher risk of capital depletion.

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Example: Jane Retiree

So let us consider changing the SWR approach. We could replace the bond allocation with a SPIA (single premium immediate annuity). Please see the ‘Annuities’ section above for more information). In practice, we generally do not purchase a SPIA. We often purchase a series of CDs and bonds first. This creates a stream of fixed cash flows going out, say, 10-15 years. Then we would purchased a deferred income annuity (DIA) that would start paying when these CDs and bonds left off. The CDs, bonds, and DIA would create a level stream of payments continuing for as long as she lives. So this would effectively create the same income stream as a SPIA. However, it would also maintain more liquidity via access to the CDs and bonds.

At Jane’s age, a SPIA might payout around 7% per year. If half of her $2m portfolio was allocated to SPIAs, this would generate $70,000 of income per year. Then the other half could be in stocks paying a current dividend yield of, say, 3%. This provides another $30,000 per year in dividends (which should grow at a rate higher than inflation). Et voila! Jane now has a portfolio that generates sufficient income for her retirement needs ($100,000). Moreover, it should grow over time and help address inflation risk.

Chiseling vs SII

If Jane had to chisel away from her portfolio, then she would be at the mercy of the market. However, Jane’s income is now naturally generated via fixed income and dividends. It is important to understand that dividends are far volatile than market prices and there are many companies who have paid and increased dividends for many years – even through the last two recessions and market collapses.

With a strategy like this, Jane does not need to worry as much about stock market volatility. Moreover, there is little to no need to manage the portfolio. So she may not need an advisor to manage her portfolio once this is set up. As a result, this can translate into significant savings. For example, consider an ongoing advisor fee of 1% per year. That would consume approximately 20% of her retirement income (1% x $2m = $20,000 out of her $100,000 of income).

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SII Simplicity

As the above example illustrates, the SII approach is remarkably simple. It can produce a reliable source of income (dividends and guaranteed SPIA payments) with reduced dependency on market performance. It can also eliminate many of the annual fees and taxes associated with the bond allocation. This is particularly relevant when comparing to a variable annuity or SWR strategy. However, SII has other benefits we have not yet discussed. SII can help minimize tax friction and maximize performance. This can translate into more income or residual wealth for legacy purposes (e.g., heirs or charities).

SII Tax Efficiency

There are three ways SII can help minimize taxes. The first way is that it involves significantly less, if any, portfolio rebalancing. Thus, it should trigger fewer capitals gains. Second, the investor effectively consumes the fixed income side of the portfolio throughout retirement (but is guaranteed not to run out!). So much of the income is actually principal and thus not taxable. Moreover, this also means that the fixed income allocation decreases through time. This is good because fixed income is generally less tax-inefficient given that ordinary income tax applies to the interest. The third tax benefit of SII stems from the use of the fixed annuity. These products defer all of the taxes until the owner starts to receive income.

Our calculations indicate these tax benefits can save many retirees the better part of 1% per year. To put this into context, consider tax savings of 0.50% per year versus a 5% withdrawal rate. This amounts to a 10% boost to retirement income via tax savings alone (10% = 0.50% / 5%).

SII Performance Advantage

SII also offers potential performance advantages. These stem from the different ways one has to manage (or not manage) the portfolio. Most other strategies rebalance and maintain fixed asset allocations (e.g., 60%/40%). They generally have to do this because their income stream is dependent on market performance. Specifically, they must keep a lid on overall volatility. Otherwise, they would risk opening the door to wealth depletion and income impairment.

Unfortunately, this rebalancing process can limit overall portfolio performance as it systematically constrains the higher growth asset (e.g., stocks). Each time stocks outpace the other investments, the SWR strategy trims the equity allocation. Then the proceeds are redistributed to other parts of the portfolio (presumably triggering taxes as well). In the words of famed investor Peter Lynch, this process is akin to “trimming your flowers and watering your weeds.”

Another Tax Angle

There is another advantage to using the fixed income side of the portfolio to secure enough income via the SPIA. It leaves the equity side of the portfolio alone to grow without constraint. In terms of risk management, this transfers risk away from the retiree’s income stream and to the retiree’s beneficiaries. This is a much better alignment as equity risk then resides with their presumably longer time horizons. Of course, a retiree may wish to take advantage of the equity growth within their lifetime. In that case, they could sell some of their equity allocation along the way. However, this would not done in such a way to systematically constrain growth and trigger taxes.

The bottom line: The above description and example brush some details under the rug (e.g., inflation). The overall approach of marrying an income annuity to a stream of dividends offers many potential benefits. First, it is both simple and efficient means to generate a robust and growing stream of income. I find SII offers the best balance of income, risk, cost, tax, and performance. As a result, I believe this approach to income produces can provide significantly more peace of mind in retirement.

Contact me to learn more

Tail Risk Hedging

Here is a link to the full article: Tail Risk.

Disclaimer: This article discusses unconventional strategies that are not suitable for most investors. Please consult a financial professional with specific expertise in tail hedging and derivatives if you are considering this or related strategies.

This article proposes tail risk hedging (TRH) as an alternative model for managing risk in investment portfolios. The standard approach via diversification involves significant allocations to bonds. However, this has historically reduced returns over the long term (see Asset Allocation article). Accordingly, it could be sensible to pursue an alternative approach by managing equity risk directly rather than avoiding or reducing it – thereby allowing investors to maintain higher overall equity allocations.

So how can one manage equity risk directly? Market timing has rightfully been associated with poor investment performance in many situations. In my view, however, much of this underperformance can be attributed to inefficient implementations involving uncomfortable tracking error (i.e., watch markets continue higher from the sidelines).

Instead of making wholesale changes to a portfolio, a tail risk (a.k.a. black swan) strategy might only comprise a 1-5% allocation. However, these positions would embed significant leverage to amplify their impact. Like card counting in blackjack, these strategies should only be employed opportunistically (i.e., when markets are vulnerable to tail risk). Moreover, their risk/reward profile should be extremely asymmetric with limited downside but significant upside potential (i.e., measured in multiples instead of percent returns).

Interestingly, I believe equity derivatives markets (e.g., put options, VIX products, etc.) currently offer attractive risk/reward opportunities due to price distortions resulting from the popularity of short-volatility products.

Figure 1: Allocate Capital According to the Attractiveness of the Opportunity

Source: Aaron Brask Capital

Overview

Tail risk hedging (TRH) strategies are effectively geared to profit from significant market corrections. They may be used alongside or to replace traditional risk management strategies (e.g., diversification via asset allocation) where the core portfolios have a significant allocation to equities or other volatile assets. They may also be used on a standalone basis to speculate and profit from market corrections (think The Big Short). We briefly discuss various applications at the end of this article.

Before delving into the details of TRH strategies, I first discuss the traditional approach to managing risk within investment portfolios. I then explain some of the vagaries associated with the often ill-fated strategy of market timing.

It is worth noting the TRH strategies discussed here are based on the equity and equity derivatives markets. However, I have also made a comparison to some of the speculative credit derivative strategies used to profit from the collapse of the housing bubble approximately 10 years ago.

Diversification via Asset Allocation

The conventional approach to managing portfolio risk typically involves diversifying investments amongst various asset classes. If the assets are not perfectly correlated, this will naturally mitigate the impact from a significant decline in any one asset class. At the same time, it will also dilute the upside potential of higher growth asset classes.

For example, consider a standard portfolio comprised of just stocks and bonds. Stocks have historically outperformed bonds by a significant amount over longer time periods (i.e., multiple percent per year). So the performance of portfolios with larger allocations to bonds have tended to lag those with smaller or no bond allocations. Indeed, when looking at rolling 10-year windows since the start of the Great Depression, stocks outperformed bonds 84% of the time. Moreover, the windows where stocks lagged bonds for a decade or more were clearly clustered around periods where stocks started with extremely high valuations (like now). I discuss the drivers behind these historical trends in more detail in my Asset Allocation article.

Figure 2: 10-year Rolling Returns

Source: Standard and Poor’s, Federal Reserve Board

Many investors (professional and retail) implement diversification via fixed asset allocations through time. That is, they maintain their percentage allocations to various asset classes via periodic rebalancing. This approach is fairly standard within the investment management industry. However, I believe this fixed asset allocation approach is better characterized by risk avoidance than risk management. Indeed, it systematically reduces stock exposures.

This leads to the challenge of how to manage equity risk without simply reducing or avoiding it. One answer is to insure the portfolio against market losses via put options. I discuss this and other strategies in the TRH section, but the bottom line is put options are very expensive and this typically results in a net-negative result over the long term. Another option is to step out of equity market at time when risks are high. This is known as market timing and is the focus of the following section.

The Painful and Rarely Successful Strategy of Market Timing

It is virtually impossible to pick the absolute tops or bottoms of markets. Asset prices are only loosely attached to their underlying fundamentals. There is a myriad of factor influencing this linkage between fundamentals and market prices. Here I discuss how the perceptions and competing interests of different investors results in a layer of noise around market prices and thereby make market forecasting more difficult. I also discuss several practical challenges to implementing marketing timing strategies.

Different Risk Profiles

Every investor has a different perspective and approach to investing. For example, younger investors may be more inclined to own stocks than older investors who have little appetite to risk put their retirement funds at risk. Moreover, every investor has a unique risk profile. Whether it is their natural personality or a particular investment experience (e.g., tech or housing bubble, scam or fraud, etc.), risk profiles are shaped by a variety of factors and can change through time.

Even when investors have similar risk profiles, they may interpret investments differently. There are competing investment philosophies (e.g., active versus passive), different investment and valuation models, and every investor has a unique educational background with respecting to investing. Take evidence-based investing, for example. One might think that investment professionals who are dedicated to analyzing investments and strategies in a scientific manner would arrive at similar conclusions. This is not that case. Different people interpret the same data differently.

Last but not least, emotions and behavioral biases can trump all of the data and analysis in the world. Whether investors are aware of their own tendencies or not, behavioral psychology has now become a major focal point for many investors, investment professionals, and academics due to its significant impact on investors. Given the inherent fickleness of human nature, this inserts yet another layer of detachment between fundamentals and market prices. Emotions are not based on rational thought but impulses and instincts. Accordingly, attempting to predict the emotional component of investor behaviors is tantamount to predicting irrational behaviors. While Dan Areily (author of Predictably Irrational) might disagree, this is virtually impossible. Investors can change their moods in an instant and this injects additional noise into market prices.

In a nutshell, market prices are subject to a broad spectrum of investor choices that lead to buying and selling decisions. It is virtually impossible to time with great precision when market perceptions or moods will change. For this reason, attempting to forecast changes in market direction can be a challenging endeavor.

In Practice

Even if one is reasonably competent in forecasting these seismic shifts in markets, it is still very difficult to successfully benefit from market timing. For example, many portfolios are taxable. So if an investor wishes to reduce exposures to equities, it will likely incur capital gains taxes. The precise amount of tax friction will depend upon the basis or unrealized gains embedded in an equity portfolio. For investors with tax-deferred accounts (e.g., 401K or IRA), this is a non-issue. Taxes aside, there will likely be transaction costs for selling existing positions (and rebuying them or other assets later). Given the low-cost brokerage options investors have today, these costs can be minimized.

A perhaps more important issue with market timing is the emotional toll it can take. I have already discussed the virtual impossibility of getting the timing perfect. Assuming one has pulled money out of equities, this means there would be a period where markets continue higher but the investor does not participate. This situation can create significant doubt and discomfort. That is, being right but too early can result in the painful feeling of lost opportunity.

Between the challenges involved in profitably executing this type of market timing strategy and the potential emotional discomfort, it is no surprise this practice is frowned upon by many investors and investment professionals. Making wholesale changes to a portfolio is perceived as an aggressive strategy – even if vindicated in the end. Thus it opens up the door to job risk as it requires an advisor to stick their neck out and invest differently. Status quo is much safer (for the advisor).

Tail Risk Hedging: An Alternative Approach to Risk Management

Whether one is reducing their equity exposure permanently via a fixed asset allocation or temporarily in the context of market timing, it affects the composition of the overall portfolio. TRH (a.k.a. black swan) strategies are typically concentrated within a smaller allocation comprising less than 5% of the overall portfolio. This allows one to retain 95% or more of their standard portfolio exposures. Specifically, this helps avoid the potential emotional rollercoaster associated with wholesale changes to the portfolio (i.e., reducing equity exposure and watching markets go up from the sidelines).

So how can such a small allocation help mitigate risks at the portfolio level? That is the $64,000 question. The obvious answer is that these positions would embed significant leverage to amplify their impact. While this is true, the real value of TRH strategies is derived from the efficiency with which they provide these leveraged upside payoffs. In other words, the cost side of the equation must be minimized relative to the upside. In my view, there are primary factors driving this efficiency which I discuss below.

Precise Risk Targeting

When it comes to markets, there is a tremendous amount of noise relative to the underlying signal. For example, long-term US stock market returns have been around 10% but volatility has been almost twice as high – averaging just over 20%.

From a TRH perspective, capturing the noise of short term market movements is not the primary goal. We want to identify and isolate the underlying signal we want to hedge – in this case being a large downside move in the equity market. This would not happen overnight; it would likely take the better part of a year or longer. In terms of hedging options, this would translate into options and derivative products with maturities of at least one year.

There are other benefits related to using longer term derivatives. For starters, multiple short term options generally cost more than similar long term options. However, the more important point, in my view, is that longer dated derivatives also embed expectations about the future (e.g., implied volatility). That means we do not necessarily have to capture the entire downside move we are trying to hedge because our positions may capture changes in market perception as well. For example, consider a two-year at-the-money (ATM) put option. If the market started to correct, then we would naturally benefit from the downside move as the option would be further in-the-money (ITM). However, we would also benefit from the increase in volatility (higher probability of a larger payoff – assuming the put was not too far ITM).

Another factor in making hedges more precise is to avoid hedging unlikely outcomes. For example, if one thinks a correction of 50% is possible but not 75%, it could be sensible to purchase put options struck around 50% but then sell puts truck around 25% (i.e., strikes as a percentage of current market levels). However, if the intention is for a hedge to benefit from changes in market perception, one should be aware that the derivatives market may place a higher probability on what you view as unlikely outcomes.

Interestingly, derivative pricing models are essentially ignorant of fundamentals. This can create opportunities but can also impose challenges in the context of TRH strategies. It is important to be aware of these issues as they can make all the difference when it comes to successfully (profitably!) executing TRH strategies.

Timing

This section could arguably be integrated into the previous section in the sense that timing the strategy is the same as being precise but in the temporal domain. That is, you only hedge tail risk when it is present.

Consider the game of blackjack. If you are a skilled card counter, then you will size your bets according to the odds of winning based on the remaining cards in the deck(s). In the context of markets, you would only execute TRH strategies when markets were vulnerable to significant corrections. In my view, this is when valuations are very high (like now).

The insurance business provides another analogy; it is generally a profitable business. What does this mean for an investor who constantly hedges their portfolios? Underperformance is likely as they are likely paying a premium for the insurance. However, if one is only opportunistically hedging, say, one third of the time, then this translates into a significant reduction to the cost of insurance.

It is also worth noting the derivatives markets have a tendency price risk (options and implied volatility) according to trailing observations (realized volatility). That means the cost of hedging often will go up after risk has surfaced but can be cheap when it is most needed. The bottom line is that it is sensible to only hedge when risk is high.

The Cost of Certainty

Another dimension of hedging relates to how well a hedge must protect against specific risk. For example, a put is a direct and structural hedge for a broad market exposure. In other words, the payoff is formulaic. This leaves minimal, if any, uncertainty with regards to the risk being hedged.

For comparison, consider a hedge whereby one takes a long volatility position instead of purchasing a put. Given that volatility has historically been strongly correlated with market sell-offs, this would likely provide a hedge against market declines. However, the payoff is not formulaically linked to the percentage decline. In fact, it could be possible for a market correction to take place gradually without much volatility. In this scenario, the volatility position would not provide a good hedge whereas the put would have. I view this situation as unlikely and believe the correlation (market declines / volatility) will persist.

In my experience, the demand for puts as the crème de la crème of hedging tools results in a persistent price premium of these options. Accordingly, it may be possible to utilize a robust but not formulaic hedge at a lower cost. One should be careful in using such hedges and ensure their payoffs are very likely to correlate with the risk being hedged. If done sensibly, these probabilistic (i.e., non-formulaic) hedges may be more efficient and thus provide potentially higher upside relative to their costs.

Potential Products for Tail Risk Hedging

Note: I mostly highlight listed equity derivatives here as they are the most popular and accessible products for most investors. In particular, I do not look at hedging products based on other assets classes nor focus deeply on products trading in over-the-counter (OTC) markets.

Below I provide a brief overview of some of the more popular products that might be used for TRH strategies. I then summarize some of the general differentiating factors between these

Puts: As discussed above, puts are the most direct hedge for insuring portfolio against a market crash. There are puts available linked to variety of popular investment indices (e.g., S&P 500 or Dow Jones Industrial Average) as well as the ETFs that replicate those indices. They are typically available across a wide spectrum of strikes and maturities. More customized puts (e.g., on a particular basket of stocks) are available in the OTC markets.

Delta-hedged options: While purchasing puts and holding them directly hedges against market declines, investors could also delta hedge their long options positions in order to gain long exposure to volatility. Readers interested in learning more about these strategies can read the appendix on volatility trading in my Zombie Market Primer article. This is strategy is likely too technical for most investors to implement on their own. However, this is why the industry created products to provide volatility exposures that do not require the hassle of delta hedging.

Volatility products: The Chicago Board Options Exchange (CBOE) has developed a variety of products based on volatility-based payoffs. There are futures which effectively provide linear exposure to the VIX at a future point in time. It is important to understand these products settle to a future value of the VIX which itself embeds future expectations of market volatility. In other words, investors who purchase or sell these futures are speculating on the different between the current and future level of implied volatility as calculated by the VIX methodology.

There are also futures on realized volatility. Technically, they are realized variance futures (variance = volatility squared). These settle to the difference between the current level of implied variance and the actual realized variance.

Realized variance futures are very different from VIX futures because there are no further expectation baked into realized variance futures when they settle; they are determined precisely by the historical price data of the index. If volatility were to spike right before expiry, it may contribute very little to the payoff since it is just one day of realized volatility. On the other hand, expectations of higher volatility in the future would be captured by VIX futures since they settle to an implied figure (the level of the VIX at settlement) that might reflect expectations for higher volatility in the future based on the recent realized volatility.

The other obvious and important distinction is that variance payoffs can provide much larger upside relative to volatility-based payoffs. However, there are also options available on the VIX which can provide additional leverage. Readers interested in more technical details may refer to my Zombie Market Primer article referenced above or my older but more technical article describing VIX products.

Product Dynamics

The payouts for the above derivative products are all different and offer investors a variety of choices for hedging (or other applications). Each product has advantages and disadvantages depending upon one’s goals. It is important to understand both the ultimate payout at expiration and the potential mark-to-market impacts. The latter is critical for the many cases where derivatives positions are not held to expiration.

In most hedging applications, the value of the hedges decays through time unless the market declines or the potential for a decline has increased. The rate of decay is linked to the amount of time until the expiration and the potential upside for the payout. More time means more things could happen (i.e., more time for risk to surface). This generally translates into more expensive hedges (e.g., 1-year put versus 1-month put).

Intuitively, one might think of risk as scaling with the square root of time. If you look at the price of one-year versus 4-year ATM puts, you will likely see the latter is approximately twice the price of the former (square root of 4 equal 2). I am leaving out some details (forward versus spot ATM, volatility surfaces, money-ness, etc.), but this is a fair characterization of risk scaling. Indeed, if you look at most derivatives pricing formulae, you will see volatility parameters followed by the square root of time (e.g., or ).

While longer expirations may be more expensive on an absolute basis, they are typically cheaper to carry. This is because each day that passes is relatively less impactful for longer expiration products. This should evident just by observing the single day passing as the percentage of time that is lost. However, it is deeper than that. If you assume risk scales with the square root of time and plot it on a chart with time on the x-axis, then you will see how the curve accelerates toward zero when moving from left to right. Technical details aside, the bottom line is that longer expiration derivatives can be cheaper to hold. This is a critical consideration when executing TRH strategies and balancing potential upside with costs to get the most bang for your buck.

Example: Consider the scenario where I hedge with 1-year ATM put options on the SPY ETF but roll it every six months (i.e., when the 1-year option has become a 6-month option). Moreover, let us assume markets uneventfully move sideways over the six months. Based on my rudimentary risk scaling approximation above, this 1-year ATM put option will lose approximately 30% of its value of those six months (square root of one minus square root of 0.5). Looking at current pricing (as of 2:52pm EST September 7, 2017), mid-market prices for approximately 1-year and 6-month ATM puts are $14.27 and $9.05, respectively. This indicates a decay of 37% in the price of the option over those six months. This is not exactly the 30% I estimated, but in the right ballpark.

On the flip side, we can use similar approximation to figure out what the breakeven for volatility would be in such a scenario. That is, in order to compensate for the loss in time value, how much higher would volatility have to go to breakeven? The current implied volatility for the 1-year ATM put option is approximately 15%. All else equal, the 37% loss due to time decay would require volatility to increase by a factor of 1.59x (1 ÷ 63%) to just about 24% for breakeven. However, all else is not equal. If volatility were to rise significantly, it would very likely involve a market decline which would further increase the value of the put option. Accordingly, the 24% breakeven for implied volatility is a very conservative (high) estimate.

The Big Short: A Comparison

In my view, equity derivatives markets are now offering compelling opportunities for TRH strategies. For a variety of reasons I have highlighted in previous articles, investors have elevated valuations for US equities. In my view, this alone provides an impetus to look at risk management or hedging strategies. However, the cost of hedging has also been artificially dampened due to the popularity and self-perpetuating nature of low- and short-volatility strategies.

For example, markets are pricing in a probability of approximately 3% for the S&P 500 to collapse by 50% or more over the next year and a half. If this were to occur, investors speculating on this collapse could turn $3 into $100 – a multiple of 33x their original investment.

Speculating specifically on a 50% decline is a risky proposition. Indeed, a decline of 49% could payoff zero. Moreover, many TRH strategies would likely decay significantly before they paid off. So the payoff multiple might be applied to a smaller capital base (original investment minus time decay). In practice, payoffs could be higher or lower (and possibly a loss) depending upon the TRH strategy employed. On balance, even when taking decay and other variables into account, I believe risk is currently underestimated by many derivative products and attractive opportunities are available where returns are better measured in multiples rather than percent.

Having said this, I do not believe the TRH opportunities highlighted above are as attractive as those found in the credit (derivative) markets prior to the credit crisis fully exploded. At the time, one could purchase credit default swaps on various investment grade collateralized debt obligation (CDO) tranches for less than 50 bps per year where that price was fixed for five years. In other words, you could have risked $0.50 a year to earn $100 (if the CDO tranche went to zero) over a five-year period. While there could be some decay and mark-to-market risk, the potential payoff could be as high as 200x the original investment ($0.50 turning into $100). Even if it took five years and the value of the tranche only fell by 50% (i.e., a recovery rate of 50%), you still would have reaped a multiple of 20x ($50 payoff ÷ $2.50 investment). In reality, the value of many CDO tranches did go to zero and the cost of protection was actually closer to $0.30 than $0.50 making payout multiples as high as 333x.

While the above multiples only refer to the ultimate payout, it is also important to consider the mark-to-market perspective many investors experience (as depicted in The Big Short book and movie). Investors who viewed these strategies through the same prism they would use for most other investments were probably extremely uncomfortable. Indeed, observing a hedge fund decline by 10-20% typically earns the investment managers a few phone calls and meetings to explain the underperformance. However, with these CDO strategies, even 2-3 basis point changes in the CDS pricing could easily result in swings of greater than 20% depending upon the leverage employed. This is one reason it is important to understand the dynamics of TRH strategies and avoid getting caught off-guard. This mark-to-market pain was depicted by many of the hedge funds shorting CDOs in The Big Short.

In a previous article (Foregoing Due Diligence) I highlighted multiple parallels between our current situation and other periods of market distortion stemming from price-insensitive strategies (e.g., the housing bubble and CPPI strategies). The bottom line is that it is very dangerous to pursue superficial investment strategies based on their historical performance. Just as structured credit products wreaked havoc on the credit markets and CPPI strategies culminated in Black Monday (-20% in a day!), passive and other price-insensitive strategies may be increasing the risk in the stock market while at the same time pushing down the prices of products and strategies to hedge the risk.

Summary and Conclusions

This article first highlighted the potential utility of TRH strategies versus traditional approaches to portfolio risk management (e.g., fixed asset allocations). I then discussed the factors I believe are critical to successfully executing TRH strategies. Lastly, I compared the current opportunities with those that were available in the period leading up to the credit crisis.

I believe the historical performance and low price tags of passive strategies have attracted record magnitudes of assets and presumably been a major driver of the higher valuations. Moreover, the currently popular low- and short-volatility strategies have made many TRH strategies much cheaper to execute. In other words, I believe it is not only a good time to hedge, but the cost of hedging has been artificially dampened. On balance, I believe TRH strategies currently provide investors with attractive opportunities. Indeed, even those without equity risk exposure (e.g., total return investors or those who simply like asymmetric bets in their favor) may find TRH strategies compelling. I do not, however, believe these opportunities are as attractive as those available in the credit derivatives markets leading up to the collapse of the housing bubble.

TRH strategies are very complex and will often end up with polarized results. As highlighted in the disclaimer above, it is important to understand these strategies are speculative in nature. In particular, their success depends on the behavior of market prices – not fundamentals. Even if a strategy will ultimately be profitable, mark-to-market risks can make the experience painful and may result in investors abandoning the strategy at the wrong time. While I did not discuss it within this article, taxes are also relevant. Indeed, gains on many TRH strategies will be realized and thus trigger capital gains (sometimes short-term) taxes where applicable.

Accordingly, I believe it is important for investors to understand these strategies before executing them. Even then, I recommend limiting allocations to these strategies. In general, I would allocate no more than 5% of one’s overall portfolio or 10% of one’s equity allocation to TRH strategies.

About Aaron Brask Capital

Many financial companies make the claim, but our firm is truly different – both in structure and spirit. We are structured as an independent, fee-only registered investment advisor. That means we do not promote any particular products and cannot receive commissions from third parties. In addition to holding us to a fiduciary standard, this structure further removes monetary conflicts of interests and aligns our interests with those of our clients.

In terms of spirit, Aaron Brask Capital embodies the ethics, discipline, and expertise of its founder, Aaron Brask. In particular, his analytical background and experience working with some of the most affluent families around the globe have been critical in helping him formulate investment strategies that deliver performance and comfort to his clients. We continually strive to demonstrate our loyalty and value to our clients so they know their financial affairs are being handled with the care and expertise they deserve.

Disclaimer

This document is provided for informational purposes only.
We are not endorsing or recommending the purchase or sales of any security.
We have done our best to present statements of fact and obtain data from reliable sources, but we cannot guarantee the accuracy of any such information.
Our views and the data they are based on are subject to change at any time.
Investing involves risks and can result in permanent loss of capital.
Past performance is not necessarily indicative of future results.
We strongly suggest consulting an investment advisor before purchasing any security or investment.
Investments can trigger taxes. Investors should weight tax considerations and seek the advice of a tax professional.
Our research and analysis may only be quoted or redistributed under specific conditions:
- Aaron Brask Capital has been consulted and granted express permission to do so (written or email).
- Credit is given to Aaron Brask Capital as the source.
- Content must be taken in its intended context and may not be modified to an extent that could possibly cause ambiguity of any of our analysis or conclusions.

options research risk tail risk

My “Repackaging” Pet Peeve

Many advisors’ portfolios of various funds, strategies, and managers effectively turn out to be the market portfolio but with significantly higher costs.

active management index investing research unnecessary fees

Zombie Market Primer

I see multiple symptoms of a dysfunctional market whereby product mechanics have displaced due diligence and resulted in widespread malinvestment.

index investing research

Foregoing Due Diligence

Robo-advisors and broad market index strategies involves little to no due diligence regarding the price paid (valuation) or asset quality.

research

Tea Leaves: Corporate Cash Trends

This article looks at US corporate cash flow trends. My research indicates easy money is drying up and companies are increasingly getting squeezed for cash.

research

The (Un-)Importance of Returns

Here is a link to the article PDF .

In my last job with a large investment bank I built two global research teams and worked with high-profile clients around the globe. Having left the big leagues to start my own firm, my clients are more diverse in terms of wealth. While I still work with some high-flyers, I mostly work with the mass affluent or millionaire-next-door types (but also some less fortunate families). To convey my previous experience when meeting new prospects, I would sometimes say “I used to work with billionaires, but now I work with millionaires.” Then someone asked me what I did to them.

Humor aside, my experience has helped me understand the varying degrees of desire and need for returns among different types of investors. All else equal, virtually everyone prefers higher rather than lower returns. However, the prudence of pursuing higher returns depends on the financial situation and goals of each individual or organization.

This article focuses on the relevance of returns for four types of investors: those saving for retirement, those with just enough to retire, those likely to leave behind a significant estate (for heirs, charities, etc.), and those with multi-generational goals for substantial wealth. For each investor type, I consider how relevant higher returns are to achieving their goals and the role their preferences may play by potentially imposing additional constraints.

On balance, I find the need or preference for higher returns generally increases with the magnitude of wealth. This is due to two primary factors: an increased capacity to assume risk and the amplification of returns over longer time frames. I discuss the nature of this trend across the wealth spectrum. In the case of substantial wealth, I quantify the need for returns and present a model for analyzing multi-generational investment goals. This provides a sensible and intuitive framework for assessing their investment strategies. My model indicates multigenerational wealth effectively needs to pursue higher returns via higher equity allocations in order to accommodate familial growth and combat inflation.

Figure 1: Factors Related to Pursuing Higher Returns

Source: Aaron Brask Capital

Overview

There are two key ingredients for most investment-related marketing pitches: return and risk. Some advisors will tout the performance of a particular investment. Others will focus on the conservative or low-risk nature of an investment – perhaps even guaranteed returns^[1]. All else equal, higher returns and less risk sound great. However, it is critical for investors to understand the importance of returns and risk in the context of their broader goals (as well as the certainty of the fees) involved in pursuing various strategies. These considerations can impact many decisions around the investment process including:

Advisor engagement (if any): Type of advisor, services, compensation structure, etc.
Financial plan and investment strategy: Asset allocation, source of retirement income, etc.
Choice of actual investments: Funds, individual securities, active or passive, etc.
Performance and cost: All of the above will impact overall performance and costs.

This article addresses the relevance of higher returns for different investors and is organized in two parts. Part I contains three sections discussing several factors involved in balancing risk and returns. The first section focuses on two key components of risk that can determine one’s success or failure in achieving their goals. The second section highlights three primary strategies for achieving higher returns. The third section discusses the concept of need versus preference when it comes to returns.

Part II contains four sections – one for each investor type. Based on the perspectives highlighted in Part I, I discuss the relevance and risks associated with pursuing higher returns for each type of investor.

Part I: Risk and Returns

1 – Dimensions of Risk

At the broadest level, I think of risk as anything that can result in one’s failure to establish and achieve reasonable goals. In the context of investments for individuals or families, these goals typically relate to their retirement, standard of living, and objectives related to their legacy (e.g., heirs and charitable causes). Given the importance of and widespread need for retirement planning, this will be the default focal point (unless otherwise stated) of this article.

I divide risk into two primary components: strategic and investment risk. Strategic risk involves the setting of realistic goals. In order to set realistic goals, one must estimate both the income required to support one’s goals as well as investment returns^[2] for various types of assets (e.g., stocks and bonds) over a typically longer term horizon (e.g., 30 years). Given the uncertainty around future spending and market returns, it is naturally important to pursue a conservative approach in both these endeavors.

Figure 2: Decomposing Risk

Source: Aaron Brask Capital

One facet of strategic risk relates to the investor’s risk profile. For example, some investors simply cannot tolerate much volatility. Accordingly, financial plans involving heavy equity allocations or insufficient allocations to less or negatively correlated assets (e.g., hedge funds) can make the investors so uncomfortable they abandon the strategy at an inopportune time (i.e., sell stocks after a period of volatility where prices have fallen significantly). A similar argument can be put forth for tracking error. If, for example, the S&P 500 has gone up by 10% but their value-based portfolio was flat or down, then an investor may feel left out of the market’s gains and want to jump ship.

The second component of risk relates to investment risk. Once one has crafted a realistic plan or strategy and identified the guidelines for their allocations to various asset classes, one must execute the investment strategy. This typically translates into selecting managers and products (e.g., investment funds) to fulfil the plan’s allocations. Assuming the return forecasts were reasonable, investment risk surfaces when a manager or product deviates significantly from their benchmark.

For example, an equity fund manager pursuing a value strategy might fall in love with some particular investments and drift into a growth strategy (in order to hang on to those stocks that are no longer value-oriented). This style drift can have an adverse impact on the overall financial plan by changing the overall asset allocation. Given that each plan is based on varying degrees of diversification, an unexpected concentration in a particular asset class, sector, or style can introduce additional risk and jeopardize the original goals.

On balance, different investments lead to different results. It is important to align the investments with the needs and preferences of investors. A significant part of this involves management of expectations. Regardless of the risks one is taking, (e.g., stocks, bonds, growth, international, etc.), it is a good idea to make sure investors are comfortable with the overall level of anticipated volatility and/or tracking error so market performance will not catch them off-guard and make them question their strategy.

A Word on Fees and Taxes

I do not delve into the issue of fees as they are a certainty, not a risk. In my view, the real risk with fees is whether a particular investment or product provides performance commensurate with the fees. Many strategies have been commoditized and are available in low-fee index funds. So it is important to weigh how likely more expensive funds will outperform a similar fund with lower fees.

Note: Many people attempt to minimize fees based on the belief that all else is equal. However, all else is not equal. For example, some index products offer better exposure to factors such as value (that I believe will more than earn their fees over the longer term) and are well worth the higher fees .Moreover, the mechanics of many low-fee index products embed subtle costs related to their performance. For more information on this topic, please read my article Index Investing: Low Fees but High Costs.

I also do not discuss taxes in this article. They are, without question, a critical consideration for financial planning and wealth management. The tax implications of financial plans and investment strategies should be discussed with a qualified tax professional.

2 – Strategies for Higher Returns

For the context of this article, I highlight three particular strategies for targeting higher returns relative to a standard 60/40^[3] portfolio (there are more, of course). Each of these strategies involves different risks and none can guarantee higher returns. In the following, I discuss the upside potential and downside risks of each strategy.

Increased Exposure to Equities

Equities have historically provided higher returns relative to bonds. Of course, there have been periods (sometimes very long) where bonds outperformed equities and there will more periods like this in the future. Periods like these confuse and intimidate many investors, but I expect this trend to continue as survival instincts and the pursuit of profit will keep capitalism alive and continue to give stocks a strong edge over the long term. For more information on why I believe this to be the case, please read my article on Asset Allocation where I also quantify the upside benefits of higher equity allocations.

In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.

Warren Buffett

The primary risk of owning stocks is higher volatility. In some cases, investors simply do not have the stomach for the volatility. Even when they can tolerate the volatility, the volatile nature of stocks can make them inappropriate. For example, some investors simply cannot afford to take the risk since it may place them at a higher risk of premature wealth depletion.

Security Selection (Factor Tilts)

Note: I only discuss equity factors here. There are factor models for bonds as well, but research indicates the higher volatility in equities creates more opportunity for factor models.

The second strategy for targeting higher returns is to invest in equity managers or funds that tilt their portfolios toward factors that have historically increased returns and are likely to do so going forward (e.g., value). In the case of factor tilts, outperformance largely stems from:

Behavioral issues: For example, investors tend to overpay for glamour stocks and divest fallen angels.
Risk aversion: Some factors involve significantly higher volatility or tracking error. So outperformance is viewed as compensation for increased risk.
Market mispricing: Recent research indicates the outperformance of many factors does not necessarily stem from higher risk. In other words, many securities are simply mispriced.

While technology and awareness might reduce the outperformance going forward, I do not believe it is likely to disappear since some of the reasons behind the outperformance are not likely to go away. In other words, risk perceptions (aversion) and human nature are not likely to change.

Just as I discussed with stock and bond performance, integrating factors does not always result in higher returns. However, I do believe value and other tilts (e.g., small size, quality, and momentum) will very likely result in better performance over the longer term. Of course, one must always weigh the fees against the likelihood and magnitude of outperformance.

Fees aside, some factor tilts add more volatility. Depending upon the correlation of the factor with the overall market, this could increase or decrease the absolute volatility level of the overall portfolio. This is an important consideration.

Factor tilts also introduce tracking error relative to the overall market. This is by construction since tilting or altering a portfolio away from the market portfolio makes it different than the market. Therefore its performance will differ from the market’s performance. As I mentioned above, sometimes performance will be better and sometimes it will be worse than the market. Investors who scrutinize risk through the lens of tracking error will have to consider this angle.

I believe there is a variety of managers and products that integrate factor tilts that are well worth their fees. Even if the outperformance and fees were a wash, sensibly utilizing factors can create more diversification within a portfolio. On balance, I find the marginal increase in fees required to integrate factors is a sensible and efficient means of targeting higher returns.

Risk Transfer

While the first two approaches are fairly well-known, I believe this third strategy to target higher returns, while little-discussed, offers a potentially more efficient and convenient approach for many investors to target higher returns while securing the income needed for their retirement.

The idea is to transfer risk away from the retirement income and concentrate it where it can be best rewarded. The best way for me to explain this phenomenon is to highlight two issues with the standard 60/40 approach and explain how my alternative structured approach to income can mitigate or avoid them.

In a typical 60/40 approach, synthetic income is generated by selling off parts of the portfolio. During turbulent periods, there can be a negative impact from selling off holdings when their prices are depressed. Of course, the converse is true as well; selling holdings when their prices are inflated can be beneficial. However, the net effect is negative and can dampen performance significantly over the long term. I provide a more detailed discussion and quantify this in my article on Structured Financial Planning. My primary point is that this standard 60/40 approach is highly dependent on market performance and market volatility can systematically dampen performance.

Another related issue with the standard 60/40 approach stems from the fixed nature of the stock and bond allocations. Maintaining fixed allocations requires rebalancing as markets move. Due the typically higher returns on the equity side, this process is generally asymmetric; it tends to redistribute the upside from the equity side over the bond side. In other words, it constrains the performance of the faster growing asset by trimming its allocation when its growth gets too far ahead of bonds. I discuss this is greater detail with my Asset Allocation article.

One way to address these issues is to build a portfolio where the investor can live off of the dividends and interest. In other words, construct a portfolio where they did not have to chisel off parts of the capital to support their retirement budget. Given the currently low interest rates and dividend yields, this requires a significant amount of wealth. For example, $100k of annual spending would require $5 million invested in a stock portfolio yielding 2% and/or 10-year equivalent bond fund.

Many investors and investment professionals apply a rule of thumb to the 60/40 portfolio approach. They assume investors can withdraw 4% of the portfolio value in the first year and then increase that dollar amount by inflation in subsequent years without depleting their wealth over 20-40 year horizons.

Figure 3: Structured Investment Income

Source: Aaron Brask Capital

So how can we close the gap between the 4% rule of the standard 60/40 approach and the 2% natural yield of stocks and bonds? One way is to take the 40% that would be invested in bonds and allocate it to a single premium immediate annuity (SPIA). As I discuss in my Structured Financial Planning article, SPIAs are really basic annuity products (investor gives cash to the insurance company in exchange for lifetime monthly payments). Moreover, they are typically competitively priced and embed little fees unlike many of the more complex annuity products.

Let’s consider a $1 million portfolio. If 40% or $400k is invested in a SPIA yielding 7% per year for the remainder of one’s life, this will generate $28,000 per year. With the other 60% or $600k invested in stocks, this will create an additional $12,000 of dividends per year. In total, this portfolio generates $40,000 per year between the SPIA and the dividends. Moreover, the dividends will typically grow at a rate that is greater than inflation. So we have generated an income stream that effectively replicates the 4% rule. There are several benefits to structuring a portfolio in this way relative to the 60/40 approach:

Risk transfer & reduced market dependence: Retirement income is generated naturally in this framework, so investors do not need to access the capital portfolio. Accordingly, they are more immune to market fluctuations. The market risk is effectively transferred to heirs, charities, and other beneficiaries of the legacy portfolio.
Transparency: This more structured plan makes it clear where income is coming from and delineates the income from the capital growth.
Lower fees: An investor does not need to pay advisor fees on the SPIA allocation and the SPIA does not charge management fees like a bond fund or manager would.
Maintenance: Depending on how the equity portfolio is managed, there can be little to no maintenance required. A set-it-and-leave-it plan could invest in a static basket of stocks or low-fee stock funds to bring the costs to almost zero.
Unconstrained growth: The equity side of the portfolio is no longer trimmed and reallocated to the bond side. It can be left to grow unconstrained.

I have brushed many details under the rug here but I provide a more detailed discussion in my Structured Financial Planning article.

Note: I am a fee-only advisor and not a licensed insurance agent. I cannot sell nor receive commissions for recommending these products. I say this only to disarm the reader since there are conflicts of interest with many financial professionals selling or recommending annuity products. That is, their advice could be influenced by the commissions they receive when selling these products. Mine advice is not tainted in this way.

3 – Quick Word on Needs versus Preferences

I believe advisors should make it clear to their clients which investments and strategy are needed and which are not. Once the needs are reasonably covered, investment strategy should involve a balance of protecting and growing the excess wealth for legacy purposes (e.g., heirs and charities). That is, an investor’s preferences only become relevant once their needs are covered.

An investor’s needs can directly require or prohibit the pursuit of higher returns. In some cases, investors will need the extra returns to achieve some long term goals. In other cases, some investments or strategies introduce risks that unnecessarily compromise an investor’s plan or goals and are thus inappropriate.

It is worth noting there is naturally some gray area between needs and preferences. For example, does one only consider needs in the context of the current owner of the wealth? Taking this further in the case of multigenerational wealth, where does one delineate needs from preferences? Is it the third or fourth generation down?

From the standpoint of investment management, needs translate into constraints. For example, securing future liabilities requires more capital allocated to typically lower growth fixed income investments. Accordingly, hedging these liabilities means less capital allocated to more volatile but higher growth assets like stocks.

When it comes to preferences, each investor’s unique experience and investing history has helped them formulate their own set of perceptions. Moreover, their personalities and instincts can also influence the way they perceive investments. These can translate into guidelines or constraints for the types of portfolios and strategies they wish to pursue. Good advisors will attempt to educate their clients and provide them with a broader context. In reality, each individual’s experience is really just a blip in the grander scope of investing history.

Part II: Relevance of Returns

In the following, I pull together the perspectives I highlighted in Part I about risk and return in the context of four investor types^[4]: those saving for retirement, those with barely enough to retire, legacy-minded investors with significant excess wealth, and those with multigenerational wealth.

Savers

If one is working and saving, they are likely headed toward a situation resembling one of the next two categories. While much of the logic I discuss for those two investor types will apply here, there are a few key differences. First, the time horizon for the investments is naturally longer and there will likely be little or no need for liquidity (access to savings and investments) while one is still working. In most cases, this will result in a higher allocation to equities and or factor tilts.

The second difference for savers is their flexibility around timing their retirement. In some cases, their financial situation may force them put off retirement and work longer to build a sufficient nest egg. Others may have more flexibility. Even when it is not necessary, some may choose to work longer. They might want to increase their standard of living or leave more to their heirs and charities. Some may simply enjoy their work or be reluctant to let go of a significant earnings stream.

In almost all cases, the option to work longer can create some additional flexibility and this can be reflected in the types of investments and strategies. For example, someone who enjoys their work may be inclined to take more risk on the investment side since they would not mind postponing retirement.

Just Enough

Planning for the just enough crowd is typically the most straightforward because needs dictate the types of investments or strategies that are viable. More volatile investments are generally not compatible with these retirees as they can introduce unnecessary risk that compromises financial security. In particular, there is little or no buffer saving that can cover potential investment losses. So certainty is the friend of an investor who has just enough to retire. In my experience, low-cost bond funds and annuities (e.g., the SPIA discussed earlier) are the most appropriate types of investments.

Significant Estate Likely

I find this situation interesting for at least two reasons. First, the very fact that there will likely be excess wealth means there is a significant buffer for risk. This opens the door to more investments and strategies. Second, the excess wealth is typically inherited by the children or put to use for charitable causes. These beneficiaries are more tangible in a sense whereas multigenerational wealth is less so. It typically benefits many people who are not yet known or even born (i.e., future spouses and children). Anyone who has been involved in constructing a long-term dynasty trust may recall the cold or impersonal nature of its rules and directives.

The likelihood of excess wealth creates a buffer with which one can assume more risk. In other words, their needs will not necessarily dictate the planning as with the just enough crowd. Accordingly, preferences become more relevant and this naturally creates additional flexibility. Assuming retirement needs have been sensibly secured, one might begin to think about integrating the goals, needs, or preferences of the beneficiaries.

In some cases, beneficiary goals may be more specific (e.g., special needs children). However, in most cases they generally amount to more is better. Given this general objective and the typically longer time horizon before the money is bequeathed, this situation allows for reasonably aggressive investment strategies. All else equal, I would typically encourage higher equity allocations and increased targeting of factors.

Of course, investors have their own preferences. Sometimes they will still want to minimize market volatility. They may simply not have the stomach to tolerate much volatility even when they believe it would likely increase their returns and the amount of money they pass on without necessarily threatening their retirement. Sometimes the optics of volatile brokerage statements is too much.

What is sensible to some is not to others. Indeed, there are many investors who are happy to take more risk once they believe their retirement is secure. Some may even have a natural inclination to take more risk (e.g., gambling instinct) and push the limits with their allocations or even leverage. At the end of the day, it is the job of the advisor to help each client construct a strategy and select investments that align with their goals and preferences.

On balance, I believe investors who are likely to leave behind legacy wealth should generally target higher equity allocations. Moreover, I view sensible factor tilts as an almost no-brainer option. As a highlighted above, I find the potential upside of integrating factors such as value, quality, small size, momentum, etc. is well worth the additional costs, volatility, and tracking error relative to a broad market equity portfolio.

I also believe my structured investment income approach is ideal for investors in this situation where the wealth will span precisely two generations. It clearly delineates wealth that will support retirement income needs from the excess wealth that will be passed on to heirs or given to charities. Implicit in this strategy is a transfer of market risk away from the retirement income and to the heirs and other beneficiaries. This concentrates risk in the area where it will best be rewarded (the equity market). Moreover, it still allows the investor to access the principal should an emergency or unforeseen even surface.

Note: The distinction between those likely to leave a significant estate behind and those with more multigenerational mindsets is gray. In the former case, one could decide to leave less to their children and divvy up more of their estate amongst future generations. In practice, there is a balance between the cost of setting up multigenerational trusts and the magnitude of impact for each of the beneficiaries. Slicing the pie into small morsels simply may not be worth the effort.

Multigenerational Goals^[5]

Disclaimer: I am not a tax or estate planning expert. One should always seek advice from a qualified attorney and CPA for multigenerational planning endeavors. The views I discuss here strictly relate to investments and the scenarios are hypothetical in nature.

Multigenerational wealth is interesting in that it naturally affords much flexibility in the context of its owner’s needs, but there are often strong preferences that can impact one’s overall strategy. In particular, families tend to limit future generation’s access and distributions – presumably to extend the longevity of the wealth. Given the longer time horizons associated with multigenerational wealth, time naturally amplifies the impact of returns. Figure 4 below illustrates this phenomenon over various time periods.

Figure 4: Compounded Returns

Period (years)

*Return*	5	10	25	50
5%	28%	63%	239%	1,047%
6%	34%	79%	329%	1,742%
7%	40%	97%	443%	2,846%
8%	47%	116%	585%	4,590%
9%	54%	137%	762%	7,336%
*10%*	61%	159%	983%	11,639%

Source: Aaron Brask Capital

Simplifying many of the planning details (e.g., administrative costs and professional fees) and brushing the complexities of tax and estate planning under the rug, there are three primary moving parts in a multigenerational wealth plan: the amount of wealth distributed or consumed per unit time, the investment performance^[6], and the longevity of the wealth. There is some flexibility in balancing these factors and it is the job of an advisor or family office to assess each client’s preferences.

Consumption

In terms of consumption, wealth may be distributed to various beneficiaries such as charitable causes, family, or foundations (that could potentially employ family members). Regardless of who are what the beneficiaries are, fewer and/or lower distributions will naturally help the assets last longer. There are many factors affecting decisions regarding the number of beneficiaries and magnitude of distributions. Some of these include:

The degree of flexibility future beneficiaries are allowed in influencing investment or distribution-related decisions
Preference to fund specific items (e.g., education)
Conditions regarding family size, ability to work, drug or criminal activity, etc.
Influencing ambitions/encouraging achievement (e.g., Warren Buffett indicated his heirs will inherit enough so they do not have to work but will most likely want to)

Without doubt, there are many factors that can influence the manner in which wealth is distributed. It is naturally a challenging task to determine guidelines for the management of substantial wealth for generations to come. Indeed, family dynamics are subject to change as is the legal landscape. There is also the delicate issue regarding how much control future generations can have over the wealth (e.g., distributions or investment strategy). Granting some control or flexibility may allow heirs to adapt to various changes. However, it may also open the door to altering the original mandate or possibly allowing some beneficiaries to raid the cookie jar. Even without this flexibility, laws and contracts are open to interpretation. So trustees can be sued for mismanagement or fiduciary breaches.

Investment Performance

While investment performance cannot be guaranteed, decisions regarding investment strategy naturally impact investment performance – and by extension, the potential magnitude and longevity of distributions. In my view, it is sensible to consider significantly higher and potentially more aggressive equity allocations than with traditional wealth management strategies.

While equities are typically assumed to have higher expected returns, most wealth strategies use bonds to diversify and reduce the overall volatility of the portfolio. The goal is to mitigate the likelihood of investors becoming uncomfortable and making bad decisions with their portfolios at inopportune times (e.g., selling during or after a market selloff).

Multi-generational wealth is different. For example, it is often administered by independent trustees instead of the beneficiaries themselves. These trustees are professionals who should know better than to fall prey to such pitfalls. Accordingly, the reason for maintaining allocations to lower growth assets such as bonds (volatility mitigation) becomes less relevant. Moreover, even if one assumes market volatility is relevant, the risk profiles of the beneficiaries (many of which may not be born) and their tolerance for market volatility are arguably more relevant than the grantor’s risk profile. Accordingly, some of the parameters that would be used to determine investment strategy are unknown.

Longevity

The third moving part is longevity; how long will the wealth last before it is entirely consumed? Longevity is perhaps the least tangible of the three factors since it will benefit many people who are not yet born or currently in the family (e.g., future spouses). Planning for an unknown set of beneficiaries naturally makes the process more challenging. For example, should one structure their wealth to benefit their currently living descendants and families? How about the next two, three, or more generations?

One concrete goal is to attempt to make one’s wealth last forever so that distributions could go on in perpetuity. However, there are laws relating to such efforts; some specifically limit the duration of trusts. Even brushing potential legal and tax issues aside, the exponential growth of families and related issues can make multigenerational strategies cumbersome to execute. The next section provides an intuitive framework for evaluating investment returns in the context of a growing family (i.e., more mouths to feed).

A Multigenerational Model

My goal in identifying the above three moving parts is to prepare the groundwork for an intuitive multigenerational model for illustrating how investment returns relate to distributions and longevity. I believe anyone making decisions in the context of a multigenerational investment strategy should consider this perspective.

My model shows how wealth grows as a multiple of initial wealth when accounting for systematic withdrawals and inflation. I believe this approach provides a valuable perspective given the exponential growth of families and the gravitational impact of inflation. Indeed, significant real returns are required to grow wealth such that it can accommodate familial growth and combat inflation in perpetuity.

I first look at real^[7] wealth multiples over a 25-year period. I believe this time frame is conservative as the average age for women to give birth in the United States is slightly higher than 25^[8] (i.e., the true growth rate for families is slower on average). The next three figures consider scenarios based on varying levels of initial distributions (that are then grown with inflation): 2%, 4%, and 6%. This is all a gross simplification; the growth of and distributions for each family will be different. Notwithstanding, this perspective can help illustrate the relevance and provide a context for the level of investment returns for multigenerational planning.

Figure 5: Real Growth Net of Initial 2% Distribution

Initial Wealth Multiple (period: 25 years)

		Investment Returns
Inflation	5%	6%	7%	8%	9%	10%
2%	1.4	1.8	2.4	3.1	4.0	5.2
3%	1.0	1.3	1.8	2.4	3.1	4.0
4%	0.7	1.0	1.3	1.8	2.3	3.0
5%	0.5	0.7	1.0	1.3	1.8	2.3
6%	0.4	0.5	0.7	1.0	1.3	1.8

Source: Aaron Brask Capital

Figure 6: Real Growth Net of Initial 4% Distribution

Initial Wealth Multiple (period: 25 years)

		Investment Returns
Inflation	5%	6%	7%	8%	9%	10%
2%	0.6	1.0	1.5	2.1	2.8	3.8
3%	0.4	0.7	1.0	1.5	2.0	2.8
4%	0.2	0.4	0.7	1.0	1.4	2.0
5%	0.0	0.2	0.4	0.7	1.0	1.4
6%	-0.1	0.1	0.2	0.4	0.7	1.0

Source: Aaron Brask Capital

Figure 7: Real Growth Net of Initial 6% Distribution

Initial Wealth Multiple (period: 25 years)

		Investment Returns
Inflation	5%	6%	7%	8%	9%	10%
2%	-0.1	0.2	0.5	1.0	1.6	2.4
3%	-0.2	0.0	0.2	0.5	1.0	1.6
4%	-0.4	-0.2	0.0	0.2	0.6	1.0
5%	-0.4	-0.3	-0.2	0.0	0.2	0.6
6%	-0.5	-0.4	-0.3	-0.2	0.0	0.2

Source: Aaron Brask Capital

As we should expect, higher (nominal) returns, lower inflation, and smaller distributions result in higher real wealth multiples for each level of investment return. Figure 5 indicates a real wealth multiple of 2.4 for 3% inflation and 8% returns. In other words, using an initial 2% distribution and 3% inflation thereafter, one requires returns of approximately 8% or higher to accommodate a doubling (well 2.4x) of the family every 25 years without sacrificing the real value of the distributions. For distributions starting at 4%, returns must reach 10%. While Figure 7 does not show it, that figure goes to 11% when the initial distribution starts at 6%.

The long-term historical performance of the stocks and bonds are around 10% and 6%, respectively. This clearly highlights the need for significant equity allocations when attempting to accommodate familial growth and combat inflation. Indeed, the above results indicate that a family that doubles every 25 years needs overall returns in the 7-11% range depending upon inflation and distributions.

Note: This discussion relates to long-term strategy and does not reflect my current tactical view on markets. As discussed in my article More Market Correction to Come, I currently view the US equity market as extremely overvalued and expect a significant correction.

Another way to look at this is to first estimate future rate of inflation and familial growth. Given these variables, we can then determine the required investment return to support a particular level of distributions (still assuming they grow with inflation).

Figure 8: Required Investment Return

Family doubles every 25 years / and 2% Inflation

Family doubles every 25 years / and 3% Inflation

Family doubles every 25 years / and 4% Inflation


Initial Distribution Level	Required Investment Return
2%	6.4%
3%	7.1%
4%	7.9%
5%	8.7%
6%	9.5%


Initial Distribution Level	Required Investment Return
2%	7.4%
3%	8.2%
4%	8.9%
5%	9.7%
6%	10.6%


Initial Distribution Level	Required Investment Return
2%	8.4%
3%	9.2%
4%	10.0%
5%	10.8%
6%	11.6%

Source: Aaron Brask Capital

Note: As a sanity check, I compared my model’s results to the 4% rule of thumb for withdrawing money in retirement popularized by William P. Bengen^[9]. I used the same 20-year period and a 50/50 portfolio Bengen used in his study. I also converted the wealth multiple back to a nominal (i.e., not inflation adjusted) figure since he did not adjust his terminal portfolio values for inflation.

While I do not have access to Bengen’s data, my results appear in line with those presented in his charts regarding terminal wealth levels. For example, his Figure 4(b) shows the wealth multiples for the above scenario in the range of 0.5-2.5x initial wealth. Integrating volatility into my model results into a two standard deviation range of 0.4-4.6x for wealth multiples. Given the number of moving parts my simplistic model did not account for (e.g., correlations), I find these results comforting – especially where the more critical downside risks are concerned.

As discussed in the following section, future scenarios will not conform to our estimates and mathematical models. However, I still believe this type of analysis is useful to relate the notions of distributions and wealth longevity to investment returns.

Other Risks and Considerations

“All models are wrong, but some are useful.” – George E. P. Box

Without doubt, models are not perfect. In real-world applications, they can only attempt to simplify or reduce the dimensionality of potentially complex decisions. Below I list some risks and considerations relevant to this investment-related modeling and decisions in a multigenerational context.

I used a simplified mathematical model in many of the example scenarios above. My goal was to highlight the logic and intuition linking multigenerational planning to investment strategy.
In the course of planning for a particular investor, family, or entity the modeling will become more precise and involve a combination of historical and Monte Carlo simulations. This approach will better address issues around sequence of returns, volatility of parameters (e.g., inflation), correlation, etc.
Families will grow at different rates and this growth rates change through time. This presents another factor to account for in any analysis. When real growth differs from projected growth, surpluses or deficits will occur. Planning should identify the appropriate release valve to absorb these aberrations (e.g., raise or reduce distributions).
Even the best planning is subject to yet unknown risks. How much do we really know about how one’s family or the investment landscape will evolve over the coming decades?
Life expectancies are rising. This may result in more generations coexisting. In other words, there may be more mouths to feed at any point in time regardless of marriage and reproductive rates. This can pose another exponential gravity on the liability side of multigenerational planning (though history indicates this growth is slow despite being exponential).

Summary and Conclusions

This article addresses the relevance or importance of pursuing higher returns for investors. In the first section, I discussed two primary types of risks investors are faced with: strategic and investment. Strategic risk relates to overall planning and setting realistic goals whereas investment risk relates to the performance of investment managers or products relative to their benchmarks. In addition to creating a plan that makes one’s goals feasible, strategic risk also relates to the ability of an investor to execute their plan. For example, some portfolios experience more volatility or tracking error than the investor is comfortable with. As such, it is important to ensure investors are likely to be comfortable with their financial plan.

The next section discussed three basic strategies to target higher returns. The first and most popular way is to increase exposures to stocks since they typically outperform bonds over the long term. This is an asset allocation decision and often revolves around one’s tolerance for market volatility. The second method was to integrate factor tilts within each allocation. For example, one could employ products, managers, or strategies that select securities based on factors have historically increased returns and are likely to do so going forward. I find the evidence for some factors (e.g., value and quality) strong enough to recommend them in virtually all cases when one is investing in stocks – assuming one can find sensibly-defined factors at a reasonable price.

The last method I highlight for increasing returns was to mitigate or remove market risk from the income stream required for retirement. This is an extremely powerful strategy as I discuss in my article on Structured Financial Planning. This approach concentrates risk in the area where it will best be rewarded (i.e., the equity market) but poses the least threat to one’s retirement.

The third and last background section discusses the concept of need versus preference when it comes to returns. Advisors should make it clear to their clients which investments and strategies are needed and which are not. Once one’s essential retirement needs are reasonably covered, investment strategy can then balance protecting and growing the excess wealth for legacy purposes (e.g., heirs and charities).

Based on the above perspectives, I get to the meat of this article and discuss the needs and preferences for higher returns^[10] in the context of the four investor types. I summarize those conclusions here:

Savers: All else equal, a typically longer time horizon and the option to work longer (or harder?) allow savers to take more risk. This can translate into significantly higher equity allocations.

Retire with just enough: Retirees who are cutting it close cannot afford to take much risk. This naturally constrains their investment options. There should be little if any equity allocations.

Significant legacy likely: By construction, one who is likely to have significant excess wealth will also have a significant buffer for taking risk before they jeopardize their own retirement. This naturally opens the door to more investments and strategies. Significant allocations to equities are typically very sensible but limited by the risk-taking capacity or volatility tolerance of the investor(s). This is why I believe my structured approach to income can be very helpful for investors of this type.

Multigenerational: Despite the obvious flexibility substantial wealth affords, preference for wealth longevity can translate into a need for significant equity allocations to accommodate the growth of a family and combat inflation. I presented a simple but useful framework for investment decisions in a multigenerational context. I also made the case for risk or volatility concerns taking a backseat since the risk will typically be managed by professional trustees who will not fall prey to emotional or rear-view decisions (e.g., sell during or after a market downturn). Moreover, the volatility will be experienced by many others who we may not yet know their risk profiles.

I have ignored many details associated with multigenerational planning as they are beyond scope of this article (and my expertise). There are, of course, tax and legal issues that should be addressed by professionals with the relevant qualifications.

About Aaron Brask Capital

Disclaimer

This document is provided for informational purposes only.
We are not endorsing or recommending the purchase or sales of any security.
We have done our best to present statements of fact and obtain data from reliable sources, but we cannot guarantee the accuracy of any such information.
Our views and the data they are based on are subject to change at anytime.
Investing involves risks and can result in permanent loss of capital.
Past performance is not necessarily indicative of future results.
We strongly suggest consulting an investment advisor before purchasing any security or investment.
Investments can trigger taxes. Investors should weight tax considerations and seek the advice of a tax professional.
Our research and analysis may only be quoted or redistributed under specific conditions:
- Aaron Brask Capital has been consulted and granted express permission to do so (written or email).
- Credit is given to Aaron Brask Capital as the source.
- Content must be taken in its intended context and may not be modified to an extent that could possibly cause ambiguity of any of our analysis or conclusions.

Be careful when the word guarantee is used. Investments in the market cannot guarantee results. Guarantees are typically provided by insurance companies and often involve significant fees or costs. ↑
In practice, one should consider the volatilities and correlations of returns as well in order to make a plan robust to many different financial scenarios. ↑
A 60/40 is a portfolio comprised of 60% equities and 40% bonds. ↑
I do not discuss those less fortunate folks because investing, let alone targeting higher returns, in generally irrelevant. ↑
While our discussion revolves around multigenerational wealth in the context of families, the same principals may apply to endowments, foundations, and other entities with longer time horizons. ↑
The trajectory of investment performance (e.g., sequence of returns) can also be relevant, but we will ignore this facet for the purposes of this discussion. ↑
Real wealth reflects the amount of wealth sustained net of inflation. Maintaining or growing real wealth broadly equates with sustaining or increasing ones purchasing power. ↑
CDC National Center for Health Statistics found the average age of mother’s at the time of their first birth was 26.3 in 2014 and rising. ↑
This rule of thumb is credited to William P. Bengen – an MIT-educated rocket scientist who ended up in financial services. His original 1994 Journal of Financial Planning article ran historical simulations for balanced portfolios and found that one could withdraw 4% of their wealth in year one and increase that withdrawal by the rate of inflation in future years without fear of outliving their money. see my Structured Financial Planning article for more details on this approach ↑
As mentioned before, I believe factor tilts are almost always sensible to use when one has allocations to equities (assuming the factors are sensibly defined and reasonably priced). As such, each time I recommend equity allocations, you can assume I also believe a significant degree of factor tilts are reasonable. ↑

research

Category: Research

Introduction to Retirement Income

Executive Summary

Four Primary Strategies for Retirement Income

Option #1: Living off dividends and interest

Real estate?

Option #2: Safe withdrawal rates (SWR)

Issues with SWR Strategies

Option #3: Annuities

Tax Benefits

The bottom line

Learn more about annuities

Keep an Eye on Costs

Two Options for Lifelong Income

The SPIA

Option #4: Structured Investment Income (SII)

What is SII?

Example: Jane Retiree

Chiseling vs SII

SII Simplicity

SII Tax Efficiency

SII Performance Advantage

Another Tax Angle

Overview

Diversification via Asset Allocation

The Painful and Rarely Successful Strategy of Market Timing

Different Risk Profiles

In Practice

Tail Risk Hedging: An Alternative Approach to Risk Management

Precise Risk Targeting

Timing

The Cost of Certainty

Potential Products for Tail Risk Hedging

Product Dynamics

The Big Short: A Comparison

Summary and Conclusions

About Aaron Brask Capital

Disclaimer

Overview

Part I: Risk and Returns

1 – Dimensions of Risk

2 – Strategies for Higher Returns

Increased Exposure to Equities

Security Selection (Factor Tilts)

Risk Transfer

3 – Quick Word on Needs versus Preferences

Part II: Relevance of Returns

Savers

Just Enough

Significant Estate Likely

Multigenerational Goals[5]

Consumption

Investment Performance

Longevity

A Multigenerational Model

Other Risks and Considerations

Summary and Conclusions

About Aaron Brask Capital

Disclaimer

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Multigenerational Goals^[5]