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With the S&P 500 index up almost 18 percent since the beginning of this year, now may be a good time to check how well your retired or near retired clients’ household assets match up with their expected spending liabilities. Their assets may have changed significantly since your last review, and their expected spending liabilities may have as well.
In my website, How Much Can I Afford to Spend in Retirement, I encourage readers and their financial advisors to utilize actuarial and Liability Driven Investment (LDI) principles to establish two separate “buckets” for funding expected household spending liabilities:
A non-risky investment bucket for funding of essential expense liabilities, and
A risky investment bucket for funding of discretionary expense liabilities
The two-bucket process involves estimating present values of future household assets/spending liabilities and categorizing them as either risky/discretionary or non-risky/essential. Different assumptions with respect to future bucket investment returns, household longevity, inflation and expected increases (or decreases) in future expenses may be employed for the two separate buckets, generally involving more conservative assumptions for the non-risky investment/essential spending bucket.
Periodically comparing the present values of household assets with the present value of household spending liabilities produces funded status measures which may be used, with guardrails, to determine when household assets and/or spending may need to be adjusted in the future to maintain the desired asset/liability balance. These periodic comparisons also help financial advisors develop recommendations for broadly adjusting their client’s portfolio investment mix between non-risky and risky investments, when appropriate.
Including non-financial assets in the client’s asset allocation calculation
Many financial advisors fail to consider non-financial assets, such as Social Security, pension and annuity payments, when developing a client’s asset allocation strategy for their portfolio. 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 rather than simply use a rule of thumb – like the 60/40 allocation approach – and apply it to the client’s portfolio of financial assets.
The next section will outline a relatively simple process that compares the present value of a client’s essential expenses with the present value of their non-financial non-risky assets to produce a preliminary asset allocation strategy to apply to the client’s financial asset portfolio. Note that under the safety-first approach I recommend, I consider “floor plan” assets to be the same as “non-risky” assets.
For more information about this process and other recommended processes (and spreadsheets that facilitate the required present value calculations), see my website.
Calculation of preliminary asset allocation
The following five steps comprise my recommended process for determining a client’s preliminary asset allocation to be applied to their portfolio of financial assets (accumulated savings).
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 (periodic 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.). The categorization of these expenses may change from time to time depending on the client’s risk tolerance and other factors. The client may designate certain expenses to be partially essential and partially discretionary.
Calculate the present value of future essential expenses.
Determine non-risky assets/investments. These are assets or investments with little or no downside risk. As noted above, they include Social Security, pension and annuity payments, CDs, bond ladders, etc. The client may designate certain investments to be partially risky and partially non-risky.
Calculate the present value of non-financial floor portfolio (non-risky) assets.
Calculate the preliminary percentage of accumulated savings allocated to non-risky investments using the following formula:
