Retirees Should Prepare For The Unexpected With A Diversified Income Portfolio

Most retirees seek to find a certain amount of stability of income as well as peace of mind to allow them to enjoy time in their retirement years. Unfortunately due to our current monetary system and our focus on stemming intermittent crisis situations we believe the world financial system carries significantly greater risks. We advise retirees to read The Black Swan of Cairo published byForeign Affairs. Authors Nassim Taleb and Mark Blyth discuss how suppressing volatility makes the world a less predictable and dangerous place.

Complex system that have artificially suppressed volatility tend to become extremely fragile, while at the same time exhibiting no visible risks.

Just as suppressing small forest fires only builds risk and brings the risk of an abrupt and significantly larger fire in the future, our collective want to suppress pain in financial markets simply builds the stockpile of risks to the system.

Our view is that investors, in particular retirees who are focused on wealth preservation, should seek to diversify into pools of assets that may have been overlooked in the past. Diversification no longer means tuning into CNBC’s Mad Money to see if the five equities you own get the Jim Cramer stamp of approval. Diversification truly means different assets classes. In today’s market correlation of equities is very high. Most often individuals limit diversification into equities from different sectors as well as allocation to bonds. We think that this type of diversification is too narrow.

Our view is that retirees should consider raising cash and diversifying among a broad portfolio of high quality U.S. equities, short duration bonds, income-generating real estate (i.e., rental properties), hard assets (e.g., gold and silver), infrastructure assets such as MLPs, and mortgage REITs.

Note: How much an investor allocates to each of these asset classes will depend the investor's specific situation and risk tolerance.

Cash and Deleveraging

While many trash the U.S. dollar due to monetary policies we think that it is prudent for retirees to “raise cash and delever.” Given a wider set of outcomes, we believe that investors should think twice about carrying debt while remaining invested. Retirees should look to “derisk” their personal balance sheets by lowering monthly payments.

Low-Beta, High Quality Dividend Stocks

With a diversified portfolioof high-quality dividend paying stocks (like the ones on the list below), retirees can generate a stable income stream that will perform well in bull or bear markets. As volatility increases (especially downside volatility), low beta dividend stocks will help dampen portfolio volatility. In general, companies with low betas will tend to be less volatile than the general market.

(Click charts to expand)

While this is not an exhaustive list of high quality dividend stocks, this sample portfolio would yield 4.8% with an average beta of 0.38.

Hard Assets

While not gold bugs ourselves, we think that retirees should allocate a small portion of their assets to gold and silver (5-10%). Our view is that the world is awash with paper assets (stocks and bonds), holding assets that are less correlated to paper assets is prudent. The world remains uncertain and more broad diversification is warranted. Our view is that gold is under owned relative to financial and paper assets.

We own gold and silver in physical and ETF forms (GLD and SLV). We follow a policy of not timing the market, but slowly accumulating these metals, as they are our insurance policy against inflation. Investors interested in vehicles that retain physical metal should look into Sprott Asset Management’s Sprott Physical Gold Trust (PHYS) and Sprott Physical Silver Trust (PSLV).

Master Limited Partnerships ("MLPs")

MLPs generally offer stable yields that are typically higher than those of common stocks. In addition, MLP returns have traditionally had low correlations with stocks and bonds, making them good portfolio diversification assets (especially in times of economic uncertainty).

As highlighted in Standard & Poor's Guide to MLPs (pdf), MLPs offer investors three distinct positive characteristics:

Tax Treatment - Since MLPs are structured as partnerships they do not pay corporate income taxes. Taxes are only paid when distributions are received, thus avoiding the double taxation faced by investors in corporations.

Consistent Distributions - MLPs face stringent provisions including the requirement to pay minimum quarterly distributions to limited partners, by contract. Thus, the distributions of MLPs are very predictable.

Energy Infrastructure – The majority of MLPs operate in the energy sector, particularly in energy infrastructure industries such as pipelines, which provide stable income streams. The performance of companies in the energy infrastructure industry is not highly correlated with the price of oil and other types of energy, but rather with the demand for energy. The demand for energy is far less volatile than commodity energy prices and generally increases steadily over time, resulting in steady, predictable cash flows for companies in these industries.

Below is a list of the seven largest MLPs, which have an average dividend yield of 5.9% and average beta of 0.54.

Mortgage REITs

Mortgage REITs are levered investment vehicles that generate income from investing in mortgage backed securities. We believe that a small allocation of to agency mortgage REITs is appropriate for retirees as these assets benefit from low interest rate policy. Income from these securities will offset declining interest from savings. See our recent article on mortgage REITs.

Unlike large capitalization U.S. equities that have benefited from a stabilized economy and are levered to growth in the economy to grow dividends, mortgage REITs will perform well in a slow growth, low interest rate world. We believe that due to the structural headwinds in the U.S. economy, the Federal Reserve will keep things on hold for an exceptionally long period of time. That said, we believe that current valuations are attractive for agency-focused mortgage REITs (see table below).

Disclosure: I am long AGNC, NLY, JNJ, MO, SO, KMP, T.