Distribution With Diversification Or Distinction?

Which method will serve you better in retirement?

Those approaching or in retirement may seek the highest returns possible for many reasons, such as leaving behind a large legacy or traveling around the world. Sometimes it may be just to stay ahead of rising healthcare costs, inflation, and taxes. At this stage of life, nobody wants to start all over again. The challenge then is how to grow the assets as much as possible without losing it all.

One method often touted is diversification of investments. The fictional Duke brothers in the movie Trading Places went from riches to rags in minutes because their holdings were concentrated (pun intended) in orange juice futures. The opposite of concentration is diversification, where the danger of lower market values is distributed amongst numerous holdings in the portfolio. Theoretically, each additional holding reduces the risk that the overall portfolio moves lower in value – if holdings have low levels of correlation between one another.

In the final analysis, asset allocation is based on theories and models. They may say past performance is not indicative of future results, but historical returns undergird a lot of the statistical models upon which this type of investment planning is based. When systematic risk rolls in as in 2008-2009, the tide usually goes out for share prices of companies operating in different industries. Investment strategist Sam Stovall noted in his article “Diversification: A Failure of Fact or Expectation? “ that since 1946, “whenever the S&P 500 suffered through a bear market (garden varieties or mega-meltdowns), all sectors posted declines.”

Diversification is technically a form of risk control, but an external force is really in control. Techniques are used to minimize the frequency and severity of losses. Importantly, losses are not guaranteed to be eliminated; they are assumed to be minimized. Investors diversify because the process offers a potentially unlimited upside.

The objective with asset allocation is to accumulate as much money as possible, and then take a percentage of this wealth in distributions. You might see varying numbers like living off of 3% or 4% of this wealth. Note that there is a connection between the value of the portfolio and retirement income generated. Again, this type of planning is based on assumptions and uncertainty. Since one usually doesn’t know their date of death, is the amount withdrawn sustainable, and too much or too little?

A completely different way of distributing is what we’ll call with ‘distinction.’ We use the latter as Merriam-Webster’s defines the term as something that is treated as separate. What if the account value’s growth was wholly separate from the income generation potential? One could know how much income would be generated at a certain time by formula and precise payout factors. This is all done without any regard to how the stock market is doing. This feature is offered through an income rider of a fixed deferred annuity issued by an insurance company.

There are different types of annuities, and we want to make clear we like fixed deferred annuities where the insurance company holds the money and contractually guarantees that a retiree’s precious resources will be shielded from stock market risk. Investing involves speculative risk, so one couldn’t go to the insurance company after losses have been incurred elsewhere in a brokerage account, for example, and then ask to be made whole.

Funds placed on deposit inside a fixed deferred annuity may not grow as much as if it were part of an unprotected diversified portfolio. If in retirement, some introspection is probably required about whether missing out on gains or forgoing losses is more important at this stage in life. Does that really matter if the income generation potential is distinct from the growth of the funds on deposit? Retirees would do well to ask themselves, “What is the purpose of my money, and what do I want these funds to accomplish?” The soul searching that comes from answering these seemingly simple queries will ultimately decide whether a retiree opts for the fork in the road that is the premise of this article: diversification or distinction. Novelist Rose Tremain once said, “Life is not a dress rehearsal.” Choose wisely.

1: Sam Stovall, “Diversification: A Failure of Fact or Expectation?” AAII Journal, March 2010

https://www.aaii.com/journal/article/diversification-a-failure-of-fact-or-expectation