Is the 60/40 Portfolio for Retirement Planning Really Dead?

Observation From the Investment Boat — Volume 3, Issue 1

By James Mahnke, CIO & Portfolio Manager at GAMMA Investment Management LLC
June 2019

On April 23, 2019, Rebecca Lake, U.S. News & World Report, wrote an article titled “Why the 60/40 Portfolio Is Dead for Retirement Planning”. Is the 60/40 allocation really dead or does it just need an adjustment?

A portfolio allocation of 60% equity and 40% fixed-income investments is a classic investment approach. But allocating a retirement portfolio with this asset mix is not without risk of the retirement objectives actually being met. Within the U.S. News & World Report article, Rebecca Lake highlights four reasons why investors should think twice about using the 60/40 portfolio allocation. Those reasons, along with some corresponding challenges, are as follows:

• Increasing longevity means some people will likely outlive their investment resources—as ever increasing assisted living and healthcare costs may quickly eat into investment principal. Is there enough growth in the 60/40 mix for a longer life expectancy?
• Diversification of the 60/40 may not provide enough downside protection.
• Market correlations between stocks and bonds are changing, implying historical correlations and resulting expected returns may not meet long-term objectives for retirement.
• And, cash flow needs of investors are not necessarily static— especially as people age, more income may be needed and the asset mix may need varying adjustments.

Increasing Longevity Shifts The Focus to even more Growth Opportunity

As people pursue healthier life styles in addition to medical breakthroughs, longevity is increasing and investors should plan for 25 to 30 years of retirement. This gift of more retirement years may be problematic if inflation rises meaningfully—expenses could exceed returns on a 60/40 portfolio and burn through principal in the latter retirement years. No one wants to run out of money. A potential solution is to increase the equity allocation from 60% to 80% and hedge part of the downside risk with fully-covered options. In essence, create a portfolio structure in which you have the downside risk similar to a 60/40 portfolio but enhanced upside if the stock market would climb. Of course, there is a cost to bona fide option hedges. But, if the markets remain volatile, value is likely added versus a traditional 60/40 allocation. In that regard, scenario analysis can show the expected risks and rewards of both allocations to make a decision on whether to pursue the potential boost in growth.

Diversification of the 60/40 may be Limited

Diversification is important at any point during a market cycle but especially if you are just entering retirement and tapping your investments to cover living expenses. What if both equity and bond markets simultaneously enter painful bear markets? That is, again, where adding fully-covered options can be a strong protective hedge and actually capitalize on volatility. Options can also likely be executed directly on most of your current holdings—removing most of the risk of not having ample diversification in a 60/40 portfolio allocation.

There is also beneficial tax treatment for gains/losses when using hedges to manage not only expected risk/reward but also your overall pairing of gains with losses with the core holdings in your portfolio to create the most efficient tax result. But, maybe the most important benefit is that hedges can be rolled and removed without changing the core holdings in your portfolio—allowing you to stay in the market without trying to market time.

Market Correlations are Changing

Not having to market time becomes even more important as some past stock and bond relationships no longer can be relied on for retirement planning. Historically, a portfolio composed of 60% S&P 500 and 40% U.S. Treasury 10-year securities annually averaged a 9% return since 1928 (source: DataTrek Research). That return shrinks to 5.9% when accounting for inflation. Today, the U.S. Treasury 10-year yields only 2.13%—a historically low level that does not provide much cushion if stocks would fall. Further, with stock valuations near all-time highs, can an annualized expected return for stocks be truly double digit going forward? This changing market environment could challenge 60/40 investors if the correlation gap between stocks and bonds widens and the expected annualized return for the next 25-30 years is materially lower than the historical average return since 1928. In other words, a “plain vanilla” 60/40 portfolio may be easier to manage but may not be necessarily in the investors’ best interest going forward given today’s market valuations. Again, scenario analysis can show the expected risks and rewards of a “plain vanilla” 60/40 portfolio versus other asset allocations with and without bona fide hedges.

Investor Cash Flow Needs are not Static

Relying on general investment rules may put investors at a disadvantage when extreme market valuations, specific needs, goals or life cycle changes are not considered. For example, a 60/40 portfolio assumes you are around age 40—using the general investment rule of 100 minus your age equals the percent to allocate to equity investments. And as you age, the rule encourages you to shift your allocation from growth-oriented equity holdings with higher risk to more income-generating bond holdings with lower risk. This rule is logical in principle…but assumes you have grown your investments enough to shift your principal from risky growth stocks to lower risk fixed-income securities. Further, the investment rule does not consider whether the market cycle is in an early to late stage. For instance, with rates so low, is there enough interest income to cover your future retirement expenses without a meaningful draw on principal and the risk of running out of money if you live longer? You could decide to “chase” high yield investments, but is the incremental income worth the additional credit risk? In the 2007-2009 financial crisis, certain high yield investments defaulted. If you pursue more risk to get more income as you age, consider hedging part of the additional risk whether associated with prepayment, credit, yield curve and/or interest rate risk. A possible solution to generate more income is selling calls and call spreads on actual holdings in your portfolio. Selling covered calls provides more income but caps your upside—selling call spreads generates slightly less income but does not cap your upside if your underlying holdings take off to the moon. Again, scenario analysis will help you decide what to do.

In sum, the good news is you are likely to live longer. The challenging news is you are likely to live longer and your expenses will be higher. To meet those potentially higher retirement expenses, use scenario analysis to guide you on asset allocation decisions not just in retirement but also over your life cycle. A static 60/40 mix as discussed may not meet your retirement objectives because of extreme market valuations, specific needs, goals or life cycle changes. Consider combining core equity and fixed-income investments with bona fide fully-covered option hedges on those holdings to take advantage of beneficial tax treatment and asymmetrical return patterns. It is those return patterns (shown in scenario analysis) that create the opportunity to capitalize on market volatility and add more income…allowing you to stay invested without market timing and ride out the market waves in your investment boat.

This information contains forward-looking statements about various economic trends and strategies. You are cautioned that such forward-looking statements are subject to significant business, economic and competitive uncertainties and actual results could be materially different. There are no guarantees associated with any forecast and the opinions stated here are subject to change at any time and are by James Mahnke, CIO & Portfolio Manager at GAMMA Investment Management LLC. Data comes from the following sources: Star Tribune, Bloomberg, Yahoo Finance, Wall Street Journal and any other public economic and financial resource deemed to provide relevant information. Data is taken from sources generally believed to be reliable but no guarantee is given to its accuracy.