FSK - Moving From Growth To Decumulation - Asset Allocation For Investors Nearing/In Retirement

2023-11-09 21:53:24 ET

Summary

• The United States is experiencing a significant increase in the aging population, with around 10,000 people reaching retirement age each day over the next 15 to 20 years.
• Investors nearing retirement need to consider the decumulation phase and focus on generating income from their retirement savings.
• An Income Factory® strategy can provide current income and continue to grow future cash flow by reinvesting monthly distributions in the portfolio.

The population of the United States is aging. It is estimated that about 10,000 people will reach retirement age (typically 65) each day over the next 15 to 20 years!

Initially, it is evident that there will be around 10,000 people (taking the total of retiring males and females) turning 65 each day for the next two decades. The right axis indicates the number of people turning 65 each month, which is an easier number to compare with the BLS monthly report on the current employment situation in the U.S. Not surprisingly, the peak corresponds to the retiring of the baby boomers.

While many investors who were born during the Baby Boom and are nearing (or now in) retirement have been taught to continually grow their portfolio balance, at some point they will need to consider the decumulation phase. When the time comes when income from retirement savings is needed to spend on lifestyle choices or just for living expenses, the account balance will begin to draw down. That is, unless there are investments in place to replenish and even grow the portfolio NAV (net asset value) during the decumulation stage. This is why asset allocation is important and should be dynamically adjusted as the needs change from portfolio growth to generating income.

An Income Factory® or IF strategy, first introduced on Seeking Alpha by my friend and colleague, Steven Bavaria , can serve to both provide current income and continue to grow the future river of cash from reinvesting monthly distributions in the portfolio. Let’s take a look at a hypothetical example for someone like me who just retired after a 40-year career. During the growth phase of my portfolio construction (in my 40s and 50s) my primary intention was to grow my portfolio balance. My focus was on mostly growth stocks that gained from capital appreciation, and I was not as concerned with dividends.

Then as I approached my 60s, I began to shift into more income-oriented holdings and used my profits from swing trading those growth stocks to begin creating an income compounding portfolio . Now that I am about to turn 65 and have retired from my full-time job, my needs are income-based. By that I mean that I will need to replace my bi-weekly paycheck with monthly distributions from my retirement account to pay my living expenses and for my travel adventures like ski trips and visits to family.

In my case, I am no longer as concerned with how much my portfolio is worth (i.e., the NAV) but I am interested in how much income I am receiving from it each month. If my living expenses amount to $4,000 per month (for example) and I am receiving $2,000 per month from my pension and part-time income, then I need another $2,000 per month to come from somewhere else, such as my retirement account (and eventually from Social Security). That means that if I draw down my portfolio by $2K each month, I would like to replace that $2K with additional income by reinvesting some of my monthly distributions back into more shares.

An IF strategy fund that has a portfolio balance of ~$400,000 and is earning an average annual yield of 10% to 12% will provide me with about $4,000 per month of income. I could then (hypothetically) take $2,000 out in cash each month and reinvest the other $2,000, which compounds over time, so it creates even more than $2K in additional future income. This is the notion behind the IF strategy and portfolio construction approach.

In times of market corrections, when prices of the portfolio holdings are dropping then the assets grow even faster when reinvesting those monthly distributions at lower prices, enabling the purchase of even more shares. As long as the income holding (fund or equity) maintains or increases the distribution each month, the future income stream keeps growing even if the overall portfolio balance declines. Those lower prices also lead to higher yields assuming no distribution cuts, so that is another way to think about the math behind that growing income stream. A $410k portfolio yielding 11% generates about the same amount of income as a $375k portfolio yielding 12%.

What Type of Income Holdings or Asset Classes Belong in an IF Fund?

The construction of an IF type of retirement portfolio generally consists of both equities such as BDCs (business development companies), and REITs (real estate investment trusts) and funds that hold equities; as well as credit-oriented funds such as CEFs (closed end funds) or ETFs (exchange traded funds) that hold fixed income such as high yield bonds, senior loans, or CLOs (collateralized loan obligations).

Many investors automatically assume that higher yield means higher risk but that is not necessarily the case. Generally, higher yields are due to higher risk holdings but there is often market “mispricing” of stocks or funds that can lead to high yield opportunities. That has been very much the case this year with BDCs, as one example. Back in March when the bank failures occurred, many BDCs were experiencing strong revenue growth and higher yields from rising interest rates but the prices of the BDC stocks were thrown out in the bathwater along with bank stocks.

Let’s look at FS KKR Capital ( FSK ) for a good example. FSK currently pays a quarterly dividend of $.70 plus a $0.05 supplemental for a forward yield of more than 14%. The YTD total return for FSK is more than 26% based on price, yet the price plummeted back in March during the bank crisis.

After reporting strong Q3 earnings this week, and even declaring additional special dividends to be paid in 2024, FSK remains trading at a price more than 20% below the current NAV, which increased to $24.89 per share. FSK is a core holding in an IF type of portfolio and with its above 14% yield it brings up the average annual yield for the overall portfolio which may have some other holdings that yield less than 10%.

That is another benefit of the IF strategy. When the distributions are paid each month (or quarter in the case of FSK), those distributions can then be opportunistically allocated to whichever holding is down in price at the time. This requires some active portfolio management, which some investors may not want to be bothered with. The IF approach is not just a DRIP and forget strategy, although that approach may also work well for more typical buy and hold investors.

Closed End Funds

To use another example from my own retirement portfolio, there are several CEFs that generate high yield income and pay on a monthly basis. Several of those CEFs that I own, and which were issued in 2021 have not performed well recently based on total return, but they yield more than 12% annually. You can read more about several of those CEFs in my recent article .

On the other hand, several senior floating rate loan funds that I own and that benefit from rising interest rates have continued to outperform this year and have increased the distributions multiple times over the past year. I wrote about several of those funds back in September. One of those, Invesco Senior Income Trust (VVR), increased the dividend for the second time this year in October. It now yields over 12.8% yet still trades at a slight discount to NAV even after a YTD total return of 16% based on price.

Then there is XAI Octagon Floating Rate & Alternative Income (XFLT), a CEF that holds both CLOs and senior loans. XFLT is a relatively new CEF (started six years ago) that offers a high yield income, currently yielding 14.5% and trades at a slight premium to NAV of about 7%. The YTD total return is 26.5% and the dividend was increased back in June of this year from $0.073 to $0.085 monthly. I wrote a detailed update on XFLT after their Q2 report in August.

Another beautiful benefit to a fund like XFLT is that it can perform well in both bull and bear markets as I explained in that article:

CLO funds in general offer investors attractive yields in both bull and bear markets. And if the economy should dip into a recession later this year or in 2024, CLO equity can offer outperformance compared to stocks or bonds due to the unique characteristics of the asset class. According to this blog from Western Asset Management, CLO equities issued just before the 2 most recent recessions outperformed other asset classes.

Alternative Asset Classes

There are several other options for generating recurring high yield income streams in an IF portfolio construction scenario without taking on too much risk. It is good to diversify your portfolio holdings in terms of both asset classes and investment vehicles. For example, there are some ETFs that are actively managed that can be used to generate high yield income. Some, such as JPMorgan Nasdaq Equity Premium Income ETF (JEPQ), use a derivative income strategy to generate a distribution that currently yields about 11% annually and offers some potential for capital appreciation. JEPQ, which derives income from options premiums written against NASDAQ 100 stocks, has a YTD total return of nearly 30% from the combination of the 11% income yield (assumed to be reinvested) along with some capital appreciation.

Utilities and Infrastructure Assets

One asset class that has really struggled in 2023 due to rising interest rates and higher inflation is the Utility sector. Typically, utilities are seen as defensive stocks and strong income generators even during a recession due to the need to “keep the lights on” even if discretionary spending wanes. But in 2023 most utility stocks and the funds that hold them have been pummeled. Out of all the US Equity sectors the YTD performance of Utilities has been by far the worst. Over the past one-year period, only Energy has performed worse and even then, only by a hair (3 percentage points). Therefore, funds that hold utilities and energy infrastructure stocks have seen terrible price performance in 2023 although several still offer high yield income distributions.

One such fund that might find itself held in an IF portfolio is Cohen & Steers Infrastructure Fund (UTF). Although the fund is down in terms of total return this year, it continues to pay a steady monthly dividend that it has consistently paid now for the past five years (see below).

UTF 5-year dividend history

This sort of situation lends itself to a possible buying scenario when looking to add lower cost shares to increase the future income stream as the price of UTF is likely to recover from what appears to be a near-term bottom in price. The only concern would be that the fund may need to reduce the distribution in the future if it is not well covered. In the case of UTF, I do not feel that is a concern right now, and others agree that it may be currently oversold and an opportunity to own shares at a good price. Buying a quality income fund at a low price is not market timing, just a good investment strategy.

Conclusion

Having an asset allocation strategy for the decumulation phase of retirement is important and should consider both the impacts of drawdowns on the overall portfolio value as well as “replacement income”. With an Income Factory® strategy as described in this article and in multiple articles as well as in a book written by Steven Bavaria, a long-term investor can grow their future income stream without needing to sell off the “seed corn” of your portfolio. In other words, the portfolio can be thought of as a sort of factory, where the output is income from monthly or quarterly distributions, and the overall value of the “factory” is not as important as the amount of income being produced each month.

That is not to say that total return is unimportant. If a particular security is continually losing value and cannot “afford” to keep paying out a high yield distribution, it may not be a good choice for the IF portfolio. In other words, if a CEF yields 12% but loses 10% in value year after year, that is probably not a good choice for an investment. But the IF strategy is a long-term strategy so it is quite possible that some years may result in underperformance of certain asset classes while others outperform (as in the case of utilities this year). This is why a diversified portfolio is necessary, to take advantage of those dips in price when they occur as long as the security eventually recovers in price and continues to pay out the distribution.

It is also a good idea to set aside some cash for emergencies, or if you have short-term needs that require more liquidity. With money market funds, CDs, and other short-term bond funds that offer yields exceeding 5% it is a good idea to have at least some of your net worth invested in more liquid assets. I discussed some of those ideas in a recent article that I wrote regarding asset allocation.

I hope this write-up has provided some good food for thought and has stimulated your appetite for income investing. Please respond with comments below if you have any additional thoughts or ideas.

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