Index Objectives

The FNRI Index's objectives constitute the greatest fundamental difference between FNRI and alternative stock and bond indices.  The objectives are designed to meet the unique needs of investors who must live off the returns of their investment capital.

1. Current and Stable Income

The FNRI Index has delivered cash flow (bond interest and stock dividends) of approximately 4% per year since its inception (as measured by its yield on cost). Because the bond portion of the index is comprised of high quality fixed income securities, the cash flow on the fixed income portion of the index was consistent throughout the crisis; the FNRI Index is not concerned with total return from the bond components.  The index’s objective is to secure a stable stream of interest payments that can be made through all market cycles with the appropriate selection of high quality bonds capable of meeting that objective.

2. Growing Income

In addition to stable income, the FNRI Index is focused on securities that provide a reasonable probability of growing income. The income growth will primarily come from the stock holdings in the portfolio.  While we may see interest rates rise, which would constitute an income increase for the bond holdings, the interest payments over the long term are not likely to rise on a real (inflation adjusted) basis. Thus, we don’t anticipate real income increases from the bond portfolio.

We rely on the dividend growth capacities of the companies in the index to provide an income stream that grows at a rate higher than the rate of inflation.

By way of illustration, below is a graph of the actual per share dividend payments for four of the companies in the FNRI Index: Johnson & Johnson, United Technologies, Proctor & Gamble and Coca Cola.  As you can see, these firms have been consistently paying and increasing their dividends since the early 1990s. What’s interesting is that their dividends grew in the 2000 to 2002 market decline and in the 2007 to 2009 crash.  While the price of these stocks may have declined, the cash flow was both reliable and increasing.  These characteristics are incredibly important to retired investors who need cash to cover living expenses.

As you can see, the dividend payments increased anywhere from 300% to 600% for these securities, which far outpaced the rate of inflation over those 16 years.  This dividend growth would provide investors with an income stream that increased their standard of living each year over the last 16 years.

While we recognize that the dividends from all companies are vulnerable, the diversification of the FNRI Index helps manage the prospects of dividend cuts. The equity holdings in the FNRI Index are well diversified and cover the 10 major sectors of the economy.

3. Principal Protection

Because equities represent less than half of the index value, during bear markets, the declining equity values have less of an effect on the investor's portfolio, thus preserving more of the investor's total capital. Yet, there is sufficient equity exposure such that in bull markets the capital gains on the equity side will add to the index's total return.

We anticipate that in a bear market, the equity holdings of the FNRI Index would decline in a manner consistent with the overall market declines. Thus, we do not anticipate that the stocks would provide any greater price stability than the overall market. This requires us to limit the equity holdings because retired investors have a limit to the valuation declines that their portfolios can support. We define a severe bear market as a decline of 50%, which we think all retired investors must be prepared to handle.

By limiting the equity holdings to 40% to 45%, in a severe bear market, the FNRI Index has an expected decline of about 20% to 22%.

While this decline would be uncomfortable, it is manageable. From studying past historical retirement distribution cycles, portfolio failure rates increase significantly once a portfolio experiences declines of greater than 25%.  Thus, the FNRI Index is structured to attempt to limit total declines to less than 25% in severe bear markets.

Moreover, the securities in the FNRI Index are selected for their ability to continue to provide income during bear markets. For retired investors, portfolios structured in this manner would help protect the investors from needing to liquidate securities or principal during bear markets, which provides another significant layer of risk management.

The FNRI Index had a start date of June 30, 2008, just prior to the severe market declines resulting from the credit crisis. Thus, the FNRI Index has been stress tested in one of the most extreme market environments most retired investors will ever see.

The FNRI Index has been certified by Standard & Poor's. S&P updates daily the price and total return value for the index.

The FNRI Index value started at 100 on June 30, 2008, and at the market low of March 9, 2009, the FNRI Index had a price value of 84, or roughly a 16% decline. The modest decline demonstrates the index's ability to provide substantial principal stability in extreme markets.

Currently, the month-end total return value for the FNRI Index value was 111.99 on August 23, 2010, which is a positive total return of more than 11% over the last 26 months.  The price component of the FNRI Index is at approximately 103, which indicates that approximately 8% of the total return over this period has been provided from the cash flow.

The cash flow nature of the FNRI Index is what makes it unique. It is designed to hold securities that can provide a steady and reliable source of income in the absence of capital gains. Thus, during periods of declining or stagnating markets, the index continues to provide cash flow, while still providing significant principal protection and the opportunity for long-term capital gains.

4. Capital Gains

Although the FNRI Index is focused on cash flow, we recognize that capital gains are an important part of maintaining a growing capital base to support a growing income stream. We believe that an allocation of approximately 40% to 45% in equities is sufficient to add 1.5% to 2.5% to the portfolio’s long term total return, which should be enough to outpace the effects of inflation once coupled with the growing dividend payments.  Our recognition of the need for capital gains is also why we allocate equities to the 10 major sectors of the stock market. We recognize that over time, equity diversification will raise the probably of price increases as the value of a diversified portfolio of stocks benefits from a growing economy.

But, because reaching for capital gains exposes a portfolio to declines of at least 50% in what we would term a severe bear market, we limit the equity exposure to 45% or less of the account.

Consequently, we believe the equity allocation is meaningful enough to add the required capital gains to help offset the effects of inflation over the long term, but small enough to not undermine the stability of the portfolio during severe bear markets.

 

 

Disclosure: The Farrell-Northstar Retirement Income Index is a list of fixed income and equity securities. The FNRI Index is for informational and educational purposes only. Investors cannot invest in an index and the FNRI Index does not represent an actual security or portfolio. Equity statistics are estimates and were obtained from Ford Equity Research for each individual equity holding in the FNRI Index. Historical dividend payments on the S&P 500 were obtained from Standard & Poor’s. Statistics for the master limited partnerships and energy trusts are excluded from the PE calculation as those securities have different financial structures that need to be analyzed under different valuation metrics. Past performance is no guarantee of future returns. FNRI Index returns have been certified by Standard & Poor's. Consult your individual financial advisor prior to making any financial decisions. Investing involves multiple risks, including but not limited to the permanent loss of capital.