Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
Neglecting non-financial assets, such as Social Security and pensions, will misstate the risk in a retired (or near retired) client’s asset allocation strategy.
As background, let’s start with a review of the most common ways that advisors construct allocations for their clients during retirement. In his paper, Asset Allocation Strategies in Retirement, Jim Otar described four popular asset allocation strategies:
-
Strategic asset allocation – Followers of this strategy decide on a suitable asset mix of different asset classes (typically equity, bonds, real return bonds and cash) and maintain this asset mix over time (by periodically rebalancing);
-
Age-based allocation – The amount allocated to equities is based on the client’s age. This is known as the “100-age rule.” This strategy produces a declining equity glide path as the retired household ages;
-
Tactical asset allocation – This is based on the premise that growth rate of equities eventually reverts to its historic mean, so allocations to equities may be reduced following a good equity investment year; and
-
Trend-following asset allocation – This is the exact opposite of tactical asset allocation.
In 2014, Wade Pfau and Michael Kitces wrote the paper Reducing Retirement Risk with a Rising Equity Glide Path, in which they argued that “rising equity glide paths in retirement – where the portfolio starts out conservative and becomes more aggressive through the retirement time horizon – have the potential to actually reduce both the probability of failure and the magnitude of failure for client portfolios.”
Other authors have proposed other asset allocation strategies, including:
- Bucketing approaches
- The 60/40 allocation
- At least 50% equities (the 4% rule)
The strategies described above have generally focused on how to allocate a household’s investment portfolio without regard to other non-financial retirement assets the household may possess. By ignoring retirement assets outside the investment portfolio, those approaches produce results that may be inconsistent with household goals and tolerance for risk.
The idea of considering non-financial assets in the development of an asset allocation strategy is not a new one. In 2001, academics Steve Fraser, William Jennings and David King wrote Strategic Asset Allocation for Individual Investors: The Impact of the Present Value of Social Security Benefits. In 2013 in an interview with Morningstar, Jack Bogle suggested retirement savers should consider the value of their Social Security benefits in their asset allocation. In 2016, in another Morningstar interview on this subject, Michael Kitces said, “If I put on my academic-researcher hat for a moment, frankly, I think absolutely Social Security should be an asset; You should be looking at it on your balance sheet.” However, he also said, “Now, I take off my academic-research hat, and I put on my practitioner hat as an adviser who sits across some clients. This gets messy really fast.”
Most financial advisors who resist reflecting non-financial assets in a client’s asset allocation strategy are worried that it will result in an over-allocation to equities that will be difficult to explain to clients. However, if the client’s objective is to fund future essential expenses with non-risky assets, it is important to consider the client’s non-financial assets, and reflecting non-financial assets in the calculations will not always result in larger allocations to equities.
The next section will outline a relatively simple process that compares the present value of essential expenses with the present value of non-financial assets to produce a preliminary asset allocation strategy that is consistent with the safety-first investment strategy.
Calculation of preliminary asset allocation
The following four steps comprise my recommended process for determining a client’s preliminary asset allocation.
1. Determine essential expenses. These are the client’s expenses in retirement that they don’t want to reduce, if at all possible. These expenses can either be recurring (annual expenses expected to last all or most of the client’s remaining lifetimes), or non-recurring (such as mortgage repayments expected to be paid off during retirement, pre-Medicare health insurance costs, long-term care costs, etc.).
2. Calculate the present value of future essential expenses (see below for more discussion of present value calculations for steps 2 and 3.)
3. Calculate the present value of non-financial floor portfolio assets
4. Calculate the preliminary percentage of accumulated savings allocated to non-risky investments using the following formula:
For example, if
- The present value (PV) of the client’s essential expenses is $1,900,000,
- The PV of the client’s non-risky non-financial floor portfolio assets (Social Security, pensions, etc.) is $1,500,000 and
- The client’s accumulated savings (investment portfolio or nest egg) is $1,000,000,
- The percentage of accumulated savings allocated to non-risky investments under the above formula would be 40% ([$1,900,000 - $1,500,000] / $1,000,000) and
- The maximum percentage of accumulated savings allocated to risky investments used to fund discretionary expenses would therefore be 60%.
This preliminary allocation would be recalculated periodically to reflect actual experience, any changes in assumptions, and any changes in the client’s estimated essential expenses.
There may be valid reasons why a client may want to increase their preliminary asset allocation to risky investments compared with the results determined using the formula described above. In this case, the household may consider actions such as reducing their planned recurring or non-recurring essential expenses, deferring commencement of Social Security benefits, or working in part-time employment.
Conversely, there may be valid reasons why an investor may not want to increase their investment allocation to equities even though this percentage may be supported using the above formula. In this situation, the client may consider increasing planned essential expenses or they may simply decide to be more conservative in their investing.
The preliminary asset allocation determined using the above approach is a data point used to start the asset allocation discussion and may be modified to reflect specific client goals, tolerance for risk and other preferences. Reflecting non-financial assets and comparing these assets with client-selected essential expenses will provide the client with important information regarding how conservative or aggressive their overall investment strategy is.
Assumptions to determine present values
The assumptions used to determine present values of essential expenses and non-financial assets in the above calculation should reflect expected returns on less risky investments. Basic financial economics tells us that the assumptions used should theoretically reflect those used to price inflation-adjusted annuities (which are no longer sold in the U.S.). Future rates of increases in essential expenses may be appropriate for different types of essential expenses (such as medical costs).
Why use present values?
Some advisors may question why it is necessary to use present values in the calculation of the preliminary asset allocation. They may think that it is sufficient to develop an allocation strategy for the nest egg that is expected to provide sufficient annual income to bridge the gap between the client’s annual income from non-financial assets and their annual essential expenses. Unfortunately, benefits payable from non-financial assets and essential expenses are frequently not linear (the same real dollar amounts each year). Using present values more accurately captures the values of non-linear future cash flows. If advisors are having difficulty calculating present values for this purpose, they should use one of the free actuarial financial planner Excel workbooks available on my website.
Conclusion
It can be a mistake to focus only on investments in one’s portfolio when developing an asset allocation strategy. Ignoring the value of non-financial assets like Social Security, pensions and life annuities will significantly understate the amount of investment risk a household may actually be taking. On the other hand, an asset allocation strategy that does not consider funding of essential expenses with non-risky investments may overstate household investment risk. Comparing the present value of essential expenses with the present value of non-financial floor portfolio assets and using the above process will provide useful information to help retired households properly balance their concurrent needs to grow, protect and carefully spend their total retirement assets.
Ken Steiner, FSA, is a retired actuary with a website entitled "How Much Can I Afford to Spend in Retirement."
Read more articles by Ken Steiner
Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
