Unless you are almost totally reliant on Social Security and/or your pension benefits, one of the most important decisions you will need to make in (or near) retirement is how to allocate your Accumulated Savings among risky investments, such as equities, and less-risky investments, such as bonds or annuities.
Many academics, financial advisors and retirement bloggers focus only on a household’s investible (or financial) assets when discussing or recommending asset allocation strategies. This focus is consistent with viewing accumulated savings (or sometimes referred to as the household nest egg) as a separate source of retirement income to be tapped using some type of Systematic (or Structured) Withdrawal Plan (SWP). These experts apparently believe that retirement assets held outside the nest egg (non-financial assets), such as Social Security benefits, pensions, life annuities, etc. shouldn’t affect how the nest egg itself is invested. Other retirement experts acknowledge that these other non-financial assets should be taken into account when developing an asset allocation strategy for the nest egg, but frequently, they do not indicate how this should actually be done.
In this post, we will discuss asset allocation strategies in general, and how we determine the asset allocation of our accumulated savings in retirement, by using basic actuarial principles and taking into account non-financial retirement assets. We even give you a simple formula to use in your planning. We also include an example of how reflecting non-financial assets can significantly affect one's asset allocation strategy.
Asset Allocation Strategies
In his paper, Asset Allocation Strategies in Retirement, Mr. Jim Otar describes 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.” Frequently known as the 100-Age Rule. This strategy produces a declining equity glide path as the retired household ages.
- Tactical Asset Allocation—"is based on the premise that growth rate of equities eventually reverts to its historic mean” so allocations to equities may be reduced following good equity investment year, and
- Trend Following Asset Allocation—"is the exact opposite of tactical asset allocation”
In 2014, Dr. 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 various other asset allocation strategies, including:
- Various bucketing approaches
- The 60/40 allocation
- At least 50% equities (the 4% Rule)
Again, however, the strategies described 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, we believe these approaches can produce results that are inconsistent with household goals and tolerance for risk. The next section will outline how we integrate non-financial retirement assets with portfolio investments to produce a more effective asset allocation strategy that is consistent with the Safety-First Investment Strategy.
Using Basic Actuarial Principles to Quantify Non-Financial Assets and Determine an Asset Allocation
At How Much Can I Afford to Spend, we advocate building a Floor Portfolio of non-risky investments to fund future Essential Expenses as a way to manage retirement risks. We use basic actuarial principles to calculate the present values (PV)
of Floor Portfolio assets and Essential Expense liabilities. To
determine the percentage of household Accumulated Savings that should
theoretically be invested in non-risky investments, we use the following
formula:
For example, if
- PV Essential Expenses is $1,900,000,
- PV-Non-Financial Floor Portfolio Assets (Social Security, pensions, etc.) is $1,500,000 and
- Accumulated Savings 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 would therefore be 60%.
The % Allocation to Non-Risky Investments will never be less than zero.
This allocation would be recalculated periodically to reflect actual experience, any changes in assumptions, and any changes in estimated Essential Expenses.
Example
In this section, we will look at how reflecting varying levels of non-financial assets can affect ones’ investment allocation strategy and spending budget. The screen shot below of the Input and Results tab from the Actuarial Financial Planner for Retired Couples shows the input, Actuarial Balance Sheet and Current Year Spending Budget for a couple with $1,500,000 in accumulated savings. This couple also has Social Security benefits and pensions. They believe their recurring essential expenses will be $75,000 in real dollars each year in the future. In this scenario #1, they also plan on recurring discretionary expenses of $50,000 per year in real dollars. They also plan on the essential and discretionary non-recurring expenses shown below. For simplicity purposes, they have assumed that the equity in their home will cover their long-term care costs.
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| (click to enlarge) |
To illustrate the effect of different levels of non-financial assets on the example couple’s asset allocation and spending budget, we also looked at two additional scenarios. For Scenario #2, we assumed the couple’s Social Security and pensions were 80% of the amounts estimated for Scenario #1. For Scenario #3, we assumed the couple’s Social Security benefits were 80% of Scenario #1 Social Security and the couple has no pension benefits. We maintained the couple’s desired essential annual recurring spending level of $75,000 per year, but we adjusted plan discretionary spending (both recurring and non-recurring) to balance the couple’s assets with their spending liabilities where necessary for each scenario. The results of the three scenarios are summarized below.
#1 Social Security and Pensions | #2 80% Social Security and Pensions | #3 80% Social Security, no Pensions | |
Accumulated Savings | $1,500,000 | $1,500,000 | $1,500,000 |
Total annual Social Security benefits | $50,000 | $40,000 | $40,000 |
Total annual pension benefits | $40,000 | $32,000 | $0 |
PV Essential Expenses | $2,302,819 | $2,302,819 | $2,302,819 |
PV Non-Financial Assets | $1,929,797 | $1,314,881 | $933,286 |
% Allocation of Accumulated Savings to Non-Risky Assets | 25% | 66% | 92% |
Spending Budget | |||
Total Recurring Essential Expenses | $75,000 | $75,000 | $75,000 |
Total Recurring Discretionary Expenses | $50,000 | $17,000 | $0 |
Total Non-Recurring Expenses | $55,000 | $55,000 | $50,000 |
Total Current Year Spending Budget | $180,000 | $147,000 | $125,000 |
The current year spending budget for the base case (Scenario 1) is $180,000, and the asset allocation of the couple’s accumulated savings between non-risky and risky investments is 25%/75%
In Scenario #2, where Social Security and pensions are 80% of Scenario #1 levels, maximum recurring discretionary expenses are reduced from $50,000 to $17,000, the current year spending budget is reduced from $180,000 to $147,000 and the asset allocation of the couple’s accumulated savings between non-risky and risky investments is 66%/34%
In Scenario #3. Where there are no pensions, the maximum recurring discretionary expenses are reduced to $0 and discretionary non-recurring expenses must be reduced by $5,000 per annum leaving s current year spending budget of $125,000. Under this scenario, the couple’s asset allocation between non-risky and risky investments is 92%/8%.
This example clearly shows how important it can be to reflect the value of non-financial assets in the asset allocation strategy applied to a household’s accumulated savings.
It should be noted that there may be valid reasons why an investor may want to increase their asset allocation to risky investments (or non-risky investments) compared with the results determined using the formula described in this post (such as in Scenario #3 above for example). 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 invest 75% or more of their accumulated savings in equities even though this percentage may be supported using the above formula (such as in Scenario #1 for example). In this situation, the household may consider increasing planned essential expenses or they may simply decide to be more conservative in their investing.
In either event, reflecting non-financial assets in the asset allocation strategy will provide the household with important information regarding how conservative or how aggressive their investment strategy really is on a total retirement asset basis.
Conclusion
We
believe it is generally a mistake to focus only on investments in one’s
portfolio when developing an asset allocation strategy for that
portfolio. Ignoring the value of non-risky non-financial assets like
Social Security, pensions and life annuities can result in significantly understating the actual 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. Including the
present values of non-financial assets in the calculations and using the
asset allocation formula discussed in this post will provide useful
information to help retired households properly balance their need to
both grow and protect their total retirement assets.
