Retirement Focus - Post-Retirement Asset Allocation

FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
August 26, 2008

Retirement Focus – Post-Retirement Asset Allocation
by Mike Posey

IN THIS ISSUE:

1. Asset Allocation And Modern Portfolio Theory

2. The Many Faces of Asset Allocation

3. Income Strategies Using Asset Allocation

4. Advantages And Disadvantages of Asset Allocation

Introduction

This week, I am going to continue the series of E-Letters dedicated to investing during retirement. As I continue this series, it’s important to note that this series discusses investment strategies that can be used after retirement, when many retirees must depend upon their nest eggs for income.

In my initial discussion of post-retirement investing alternatives in the May 27 Retirement Focus, I mentioned that there are a myriad of ways to invest during the payout phase, each with its own set of advantages and disadvantages. For purposes of our discussion, I placed these investment strategies into the following broad categories:

1.         Immediate Annuities;
2.         Fixed Income Alternatives;
3.         Variable Annuities;
4.         Asset Allocation Alternatives;
5.         Actively Managed Strategies; and
6.         Other Alternatives.

I covered the first two of these alternatives in the May 27 E-Letter, and discussed variable annuities in the July 15 issue. This week, I’ll move on to alternative #4, Asset Allocation and its many variations. Like variable annuities, asset allocation provides the potential for higher gains and the prospect of higher withdrawals during retirement, but at a cost of higher risk.

As always, I need to point out that any investment information provided in this E-Letter is general in nature, and should not be construed as investment or insurance advice. You should always evaluate insurance and investment options in light of your personal financial situation, retirement goals and any special circumstances you may have. Ideally, you should consult with a qualified insurance agent and/or investment professional who can take the time to review your situation and tailor an investment approach to meet your needs.

The Basics Of Asset Allocation And Modern Portfolio Theory (“MPT”)

The concept of asset allocation could be called the embodiment of the old adage about “not putting all of your eggs into one basket.” You don’t have to look very far to find life lessons about violating this rule. Just ask employees of WorldCom or Enron, whose retirement savings were largely tied up in company stock, and they will likely attest to the importance of diversification. Investors who loaded up on questionable tech stocks in the late 1990s, only to see them fall 70% or more later on, can also sing a verse from that same sad song.

Though we often see investors who fail to pay attention to the need for diversification, the fact is that asset allocation has been around for a long time. Wise investors have long spread their investments over a variety of alternatives, so as not to have a portfolio too concentrated in one stock or asset class. Historically, the method for diversifying a portfolio was largely one of personal preference. That is, until a method to quantify the balance between risk and return was developed.

One of the major building blocks of modern asset allocation is a 1952 study by Nobel Laureate Harry Markowitz. This study, which introduced the concept of “Modern Portfolio Theory,” or MPT for short, was among the first to measure and quantify the benefits of diversification. The result was a way to mathematically optimize the risk/reward balance in a portfolio, something Markowitz called the “Efficient Frontier.”

However, it wasn’t until the 1980s that Markowitz’s MPT idea gained traction. In 1986, another study was published by Gary Brinson and others which concluded that apprx. 90% of the variance of returns in any given portfolio could be explained by the way assets were allocated among various asset classes (stocks, bonds, real estate, etc.). According to that study, stock selection and other factors accounted for only 10% of return variation. Taken together, these studies formed the basis of the modern asset allocation movement.

It is important to note that not everyone has jumped on the asset allocation bandwagon. There are plenty of critics that point to shortcomings in the studies that serve as the foundation of the modern incarnation of this money management strategy. I’ll discuss these in further detail later on when I cover possible disadvantages of asset allocation strategies.

Before that, however, let’s explore the various forms asset allocation programs may take. It may surprise you that some highly touted investment products are nothing more than asset allocation programs in disguise.

The Many Faces Of Asset Allocation

As noted above, asset allocation is one of the most popular and pervasive money management strategies used today. It is employed by not only investment professionals, but also by many individual investors who utilize free Internet resources to determine their allocations.

In the discussion above, I provided a few of the key words that you might look for when evaluating whether an investment alternative is based on asset allocation. If you hear your financial advisor say something about “MPT,” or the “Efficient Frontier,” or that the way assets are allocated is the #1 determinant of portfolio performance, then you are likely dealing with an asset allocation strategy.

However, asset allocation programs are not always identified as such. In this time of specialization, many investment professionals and even financial services companies do not want to publicize that they are simply doing asset allocation like everyone else, even if that’s exactly what they are doing. For example, an Advisor who wants to impress clients with his or her stock picking skills will certainly not want to dwell on the Brinson study which found that 90% of a portfolio’s performance can be explained by asset allocation and only 10% by stock selection and timing of asset purchases.

Below, I have provided a variety of ways you might see asset allocation marketed, some clearly marked as asset allocation and others not so clear:

1. Brokerage Accounts – Everyone from the large New York wire houses to independent Investment Advisors often use brokerage accounts to employ asset allocation strategies. While brokerage accounts can hold individual stocks and bonds as well as mutual funds, in this section I’ll just deal with individual securities, since mutual funds are discussed in more detail below.

As a practical matter, when individual securities are used, it is sometimes hard to determine whether a traditional asset allocation strategy is being employed. As I noted above, the broker may want to come across as a great stock picker, so asset allocation may be kept in the background. Plus, a properly diversified portfolio of individual stocks and bonds will often contain a large number of securities, so even going through your account statement can be quite a chore. This need for diversification can also lead to high minimum investment requirements on such accounts.

If you received a formal proposal before investing, this information often discusses the strategy to be employed. If you read through the proposal and notice some of the key words I have discussed above, chances are you are in an asset allocation program. However, the real key to understanding your brokerage account investment lies in asking your investment professional the right questions, such as what methodology your broker is using to diversify the portfolio.

For brokerage accounts used in retirement, it is important to monitor the amount of trading, which will directly affect expenses in the account. Unscrupulous brokers sometimes “churn” accounts, meaning they buy and sell needlessly, to increase brokerage commissions to themselves. While this is a detrimental practice in any account, it can be especially harmful in a retirement account where these brokerage expenses may reduce the amount of income that can be paid from the account. Remember that asset allocation is a buy-and-hold approach, so frequent trading should not be necessary.

A possible advantage of a brokerage account during retirement can be selection of specific bonds or other income producing securities that may have higher interest payments than might be available from a mutual fund or ETF that holds many different bond issues. Of course, the opposite might also be true.

2. Mutual Fund Programs – Mutual fund-based asset allocation programs are probably the most common types seen. The automatic diversification of the mutual fund, coupled with the ease of targeting specific asset classes makes these programs a natural fit. In many respects, a mutual fund program is much like the individual stock brokerage account listed above, except that it usually contains fewer holdings and can be accessed at lower minimum investments.

Mutual fund-based asset allocation programs come in a variety of colors and flavors, but I usually lump them into two general categories – those that use actively managed mutual funds and those that use low-cost index funds. Programs using actively managed mutual funds seek not only to find the correct asset allocation mix for a particular client, but also the best individual mutual fund within each asset class. This is not always easy to do among the thousands of mutual funds in existence, but the Morningstar database and sophisticated evaluation software help to ease the burden.

Asset allocation programs using stock and bond index mutual funds are becoming more prevalent as the number of index-related funds continues to grow. You can now find an index mutual fund based on just about any stock or bond index you’d want to include in an asset allocation portfolio.

More importantly, those who promote index investing point again to the 1980s Brinson study which concluded that up to 90% of the performance of a given portfolio is based on the way assets are allocated. Why pay the generally higher fees associated with actively managed mutual funds when you can get 90% of the same benefit from low-cost index funds in the right asset classes? Of course, this also assumes the Brinson study is accurate, which is the subject of much debate in the financial services industry.

The fee differential can be especially important during retirement, since expenses must be netted out of investment returns before they are distributed for income. As a general rule, the higher the expenses in an asset allocation strategy, the lower the income. Many who practice asset allocation concentrate on a fund’s expense ratio to help select funds. Here, those using index funds have an advantage, since these funds usually have lower expense ratios than actively managed funds. As a general rule, mutual funds with front-end loads or deferred sales charges should be avoided.

3. Deferred Variable Annuities – While I covered the subject of variable annuities in a previous Retirement Focus E-Letter, it is worthwhile to mention that many professionals who recommend these contracts also utilize asset allocation methodologies for selecting the various sub-accounts in which to invest. Beyond that, these contracts operate much like the mutual fund portfolios discussed above, so I won’t repeat that again. Just remember that deferred variable annuities can have significant lock-up periods and high surrender charges, which may make them inappropriate for those in retirement.

4. Exchange Traded Funds (ETFs) – ETFs are a relatively new phenomenon and are proliferating at a fast pace. Essentially, an ETF might be described as a hybrid of a mutual fund and an individual stock, so much of the above discussion concerning mutual funds also applies to these instruments. The ETF is made up of a variety of stock or bond holdings, usually in a way that seeks to emulate a particular stock or bond index. However, unlike mutual funds that trade only once per day, ETFs can be traded throughout the day just like a stock.

The first ETF was the Standard & Poor’s Depository Receipt (SPDR), usually referred to as the “Spider,” created in 1993. Since then, it has been joined by literally hundreds of other ETFs that seek to mimic the performance of a variety of domestic and international stock and bond indexes. There are now even ETFs that track the performance of specific commodities and a variety of commodities indexes.

As a practical matter, the ability to buy or sell an ETF at any time during the day is of questionable value in an asset allocation strategy since the primary purposes is to buy and hold securities in various asset classes. The real value of ETFs is in the variety of stock, bond and other indexes that are represented, and expense charges that are usually about half of those of index mutual funds. Again, low expenses can mean more money in the retiree’s pocket.

5. Target and Lifestyle Mutual Funds – Other relatively new entrants on the retirement scene have been so-called “target” and “lifestyle” funds. These mutual funds are examples of investments that may not appear to be based on an asset allocation strategy, but are definitely in that camp. Both target and lifestyle funds seek to meet investor goals by providing a pre-set asset allocation strategy within a single fund. In most cases, these funds allocate their assets among other mutual funds that fit the asset class criteria.

While the terms “target” and “lifestyle” are sometimes used interchangeably in the financial media, there are definitely differences that you need to know about, which I will discuss in more detail below.

Lifestyle funds are generally considered to be funds that contain an asset allocation that remains relatively static over time, and is geared toward a particular risk tolerance. For example, conservative, moderate and aggressive risk lifestyle funds are common. Each invests its assets to match the asset allocation appropriate for the governing risk tolerance, and only minor changes are made over time. For retirees, there are lifestyle income funds with an asset allocation designed to provide long-term retirement income.

In contrast to the lifestyle funds, target retirement funds (also sometimes called “life-cycle” funds) are designed to gradually modify the underlying asset allocation based on the advancing age of the investor. These funds start out more aggressively and then gradually become more conservative as retirement nears. After retirement, the asset allocation is set to provide retirement income, much as in the lifestyle income fund described above.

The obvious benefit of these funds is that they can provide a “one-stop” solution for investors who cannot decide upon an optimal asset allocation. This is especially true prior to retirement in 401(k) plans where participants must select their own investments. However, it’s vitally important to know whether the asset allocation will be adjusted over time, or stay roughly the same.

One possible drawback of many of these offerings is that they consist of mutual funds managed by the fund family that sponsors the target or lifestyle fund. This results in a concentration into a single fund family. Plus, unless you are using index funds, it’s highly unlikely that a single fund family will have the top funds in every asset class.

A possible solution is a variety of variable annuities that offer target and lifestyle sub-accounts. Many of these variable annuity contracts select funds from a variety of fund families, thus providing additional diversification to the investor.

A final word about target and lifestyle funds is that if you want to use these funds, you probably need to use only these funds. Since these funds have their own pre-set asset allocation, placing only part of your assets into this type of fund and then investing the remainder differently may actually negate the diversification benefits in the target or lifestyle fund.

That being the case, I would only recommend these funds to those who simply don’t want to or are incapable of making their own investment decisions and want a fund family or insurance company to do it for them.

This is obviously not an exhaustive discussion of all of the possible ways you can access asset allocation. However, it’s enough to let you see that asset allocation strategies are very prevalent, and are likely to become more so as the Baby Boomers retire. Just remember that any MPT-based asset allocation strategy has its gaze fixed in the rear-view mirror. To the extent that the future performs like the past, then they will likely be successful. If not, then you might not achieve the level of income you desire in retirement. That’s why periodic monitoring of the allocations and results is absolutely necessary, whether in a pre-retirement or post-retirement program.

Income Strategies In Asset Allocation Portfolios

Just as there are a myriad of ways to practice asset allocation, there are almost as many ways to take income from an asset allocation portfolio. For the sake of simplification, I have placed the alternatives into two very broad categories: portfolios managed for income and portfolios managed for growth. I’ll discuss each in more detail below.

Portfolios Managed for Income – This asset allocation technique leans toward fixed income investments and dividend producing stocks in order to provide a stream of retirement income. While some equity investments are usually included in income portfolios, the concentration of fixed-income investments usually makes the overall portfolio more conservative in nature.

In most cases, income produced by the fixed income investments is paid out of the account for retirement income purposes. In brokerage accounts, it’s common for the income to be swept to a money market or cash fund where it can be easily withdrawn. All or part of your dividend and interest income can also be reinvested if not needed for current retirement income.

In an optimum scenario, income produced by your portfolio would provide sufficient retirement income when combined with other sources such as Social Security benefits and any traditional pension benefits you may have. The downside of an income portfolio is that the types of investments included in such an allocation may not provide sufficient growth for the future, especially in light of ever-longer life expectancies.

While many income portfolios assume that the principal will remain invested and not be touched, this may not be feasible if the income produced by the portfolio is insufficient for retirement needs. In such cases, you and your advisor will need to determine an appropriate withdrawal percentage as I discussed in my February 19 E-Letter.

A final word about income portfolios is that, as a general rule, the important factor is the income produced, and not the periodic value of the underlying assets. Unless it’s necessary to invade your principal, you usually don’t need to worry about the current value of bonds or income producing stocks in your portfolio as long as they are producing the level of income that is expected from them. This is especially true with individual bonds, since market values may vary widely over time, but the full par value will generally be paid if the bonds are held to maturity.

Portfolios Managed for Growth – This asset allocation strategy is designed to attempt to maximize gains, which could be from a combination of capital gains and income from investments. As noted above, income portfolios may not provide sufficient growth to cover inflation over ever-expanding life expectancies. A portfolio managed for growth is designed to overcome this shortcoming by including more in the way of growth investments such as equities, which have historically outperformed fixed income investments.

The method for taking income from a growth portfolio is typically by means of a set withdrawal percentage, as I discussed in my February 19 E-Letter. To the extent that the desired withdrawal percentage exceeds dividends or interest produced by income investments in the portfolio (if any), equity assets will have to be sold to produce the needed additional liquidity.

A growth portfolio has the potential to provide a higher level of income, assuming the growth of the overall portfolio exceeds income available from an income portfolio. However, since growth portfolios generally have higher allocations to equity securities, there is also a greater potential for loss.

It works this way: As I noted above, a decrease in the value of a fixed income portfolio may not adversely affect the income paid from the portfolio, assuming interest and dividend payments remain the same. In a growth portfolio, however, the withdrawal percentage determines the level of income, but the performance of the portfolio determines the extent to which principal may be invaded. In years when equities lose money, withdrawals are taken on top of these losses.

Thus, if equity investments are too aggressive or if market conditions are bad for an extended period of time, a growth portfolio has the potential to underperform an income portfolio, and possibly even drop to a level of income that is insufficient for retirement needs. This is why periodic monitoring of the performance of your asset allocation strategy is imperative.

Another factor relating to which of these alternatives may be best is the issue of taxation. For tax-qualified accounts such as IRAs, all proceeds are paid out as ordinary income. Thus, the goal with your IRA asset allocation should be to maximize returns, since none of the income will be subject to special capital gains or dividend tax rates.

For taxable accounts, we currently have very favorable dividend and long-term capital gains tax rates, which should be considered when building a post-retirement portfolio. After all, money paid in taxes is not available for spending. However, you must also remain aware of what’s going on in Washington, as a change in tax policy could mean a change in your asset allocation strategy. Don’t expect your broker or financial advisor to automatically contact you when tax laws change. Instead, you need to be proactive and contact your advisor as soon as you hear of changes that may affect the way your money is invested.

Pros And Cons of Using MPT During Retirement

As with virtually any money management strategy, asset allocation has both advantages and disadvantages. In addition, there are a number of very smart experts who say that the use of MPT and the Brinson study are not appropriate for asset allocation, or at the very least, lead to a misguided opinion. Thus, it is useful to discuss some of the major positives and negatives of MPT-based asset allocation:

Advantages of Asset Allocation:

1. First and foremost, asset allocation generally provides a method for investing that is a technically based method of diversification and not dependent upon the opinion of the advisor or investor. While the basis for asset allocation comes from historical relationships among asset classes, it’s at least a way to include a mechanized analysis and allocation strategy based on an investor’s age, risk tolerance and a variety of other factors.

2. When I discussed the use of immediate annuities after retirement, you will recall that the fixed immediate annuity provides a constant level of income over the lifetime of the individual, and also that of a surviving spouse if the joint and survivor option is chosen. An asset allocation portfolio also has the ability to provide lifetime income, but it also has the potential to provide increasing levels of income based on prevailing interest rates and/or equity returns.

3. Another advantage of asset allocation over fixed immediate annuities is that an investor’s money is not locked up in a contract, and is available for emergency expenses, if necessary.

4. Asset allocation portfolios with significant equity holdings have the potential to continue to grow and even provide an estate for surviving heirs.

5. A properly established asset allocation portfolio offers the chance to periodically rebalance the account, at which time the investor’s needs and risk tolerance can be verified, and changes made within the portfolio as may be necessary.

6. Finally, basic static asset allocation has led to a number of variants, some of which are known as “dynamic” asset allocation and “tactical” asset allocation. These alternatives seek to address some of the criticism of static asset allocation by allowing for deviations from the normal asset allocation mix in order to take advantage of perceived investment opportunities.

Disadvantages of Asset Allocation:

1. While asset allocation is a very common strategy used in pre-retirement, its advantages do not always flow through to post-retirement investment portfolios. That’s because pre-retirement asset allocation often involves “dollar cost averaging,” where assets are contributed over a long period of time during various market cycles. Post-retirement asset allocation usually means investing the entire portfolio at one time.

2. Asset allocation strategies can provide income over the course of a retiree’s lifetime, but it cannot guarantee a set level of payments as can the fixed immediate annuity. If portfolio performance is poor, especially in the early years, it’s even possible to run out of money in an asset allocation portfolio, depending upon the withdrawal strategy used.

3. As noted above, asset allocation is based on historical relationships among asset classes. However, these relationships change over time. The Rydex mutual fund family has published an example of how the “Efficient Frontier” has actually been very different over the course of the last five decades. Since the performance of a retiree’s asset allocation portfolio will depend upon the relationships among asset classes over the next 20 to 30 years, which among these variations will be the “right” one for the retirement scenario? (Click HERE to see the Rydex flyer.)

Just in the last 10 years we have seen that there are some chinks in the asset allocation armor. Specifically, asset allocation holds that diversifying among equity asset classes, such as large-cap, mid-cap and small-cap stocks, or growth stocks and value stocks, etc., etc. will protect the portfolio since each asset class has a different risk and reward structure. However, the bear market of 2000 – 2002 showed us that when times are tough, all equity classes sank together. Some had greater losses than others, but most equity asset classes were under water.

4. As previously discussed, there are many critics of the 1980s Brinson study. As noted above, the original study claimed that asset allocation explained apprx. 90% of the variation of returns among portfolios. However, critics point out that variation of returns and level of returns are two very different things. Some even claim that Markowitz’s MPT concept was “hijacked” to address portfolio strategies that it was never intended to apply to.

I am not going to try to referee the fight between those for and against asset allocation. However, the view that MPT was never intended to address modern asset allocation might be at least partially validated by a revelation in 2005 that Markowitz did not use MPT-based asset allocation when investing his own money. Gary wrote about this surprising news in his May 24, 2005 issue of the Forecasts & Trends E-Letter.

5. Investors often see asset allocation as a “set it and forget it” type of strategy. Nothing could be further from the truth. Allocations need to be rebalanced over time, and possibly significantly altered due to a change in an investor’s personal financial situation. Failure to do this, whether on the part of the investor or the advisor, can lead to the failure to provide adequate retirement income.

6. Finally, it’s impossible to know which allocation is correct for the future. I noted above how there is disagreement in the financial services industry as to the appropriate allocation to equities in a retiree’s portfolio. Some suggest 20% and even less, while others maintain that a minimum of 50% should be kept in stocks. Which is right? As usual, it depends.

Conclusions

While asset allocation (and its many variations and incarnations) is a very common pre-retirement investment strategy, we have seen that not all of its advantages follow through to post-retirement portfolios. I think the extensive use of MPT-based asset allocation comes down to an old adage that says: “If all you’ve got in your tool kit is a hammer, then every problem looks like a nail.”

The financial services industry is heavily invested in the concept of asset allocation. Just look at the proliferation of mutual funds and ETFs based on the various asset classes. Before MPT-based asset allocation became popular, such specialization was less common. Now, funds have to fit into the MPT software’s asset allocation chart or risk being totally ignored.

Even so, an appropriate asset allocation properly monitored can be a successful strategy for those in retirement. Such portfolios stress the importance of diversification among different types of investments, and usually involve periodic monitoring to assure the original allocation is still viable for the investor. Monte Carlo simulations have also been helpful. These simulations project the probability of success of a given allocation. While not perfect, a Monte Carlo simulation does introduce the concept of losses to retirees, and how this can affect their ability to meet their retirement goals.

Next time, I’ll address the idea of actively managed investment strategies.

Best regards,

Mike Posey