How can retirees optimally segregate reliable income from risky growth? In their November 2011 paper entitled “The Floor-Leverage Rule for Retirement”, flagged by a subscriber, Jason Scott and John Watson examine a retirement allocation strategy that strictly segregates safe income-generating assets (“riskless” bonds) from potentially income-boosting risky assets (stocks). They designate the safe allocation as the floor portfolio, funded to guarantee a real income level in perpetuity. They designate the risky allocation as the surplus portfolio, which invests all remaining funds to capture a risk premium. If the risky assets perform well, the retiree periodically moves funds from the surplus portfolio to the floor portfolio and thereby increases guaranteed income. In assessing this floor-surplus approach, the authors assume that the riskless bonds generate a steady 2% annual real return and that the risky assets offer a 6% annual risk premium with 18% annual volatility (like the U.S. equity markets over the long run). Based on analysis of several case studies using these return assumptions, they conclude that:
- An 85% floor allocation and 3X leverage for the surplus allocation are near optimal across a wide range of retirement scenarios. Specifically:
- Invest 85% of available assets to secure a real or nominal income floor via riskless bonds or an annuity. A real (nominal) income floor implies a lower (higher) initial spending level.
- Invest the remaining 15% in a 3X-leveraged surplus portfolio.
- Each year, if the surplus portfolio comprises more than 15% of the combined portfolios, reallocate the excess to the floor portfolio.
- A number of exchange traded and traditional mutual funds, such as ProShares UltraPro S&P500 (UPRO), offer leverage.
In summary, analysis based on simple assumptions suggests that an 85% allocation to low-risk income-producing assets and 15% allocation to high-risk (3X-leveraged) potentially income-enhancing assets is near-optimal for many retirees.
Cautions regarding conclusions include:
- Real interest rates are, and have been for several years, around zero. The current monetary regime is very bad for the floor portfolio. There is no guaranteed level of real income.
- Leveraged ETFs such as UPRO are set up for daily tracking and may not deliver targeted leverage over the long run. See “Unintended Characteristics of Leveraged and Inverse ETFs” and “Multi-year Performance of Leveraged ETFs”.
