Today’s classic retirement planning study is the 2004 book, Asset Dedication: How to Grow Wealthy with the Next Generation of Asset Allocation, by Stephen J. Huxley and J. Brent Burns.
This book is very interesting and speaks to some very important issues for retirement planning and so it is hard to know where to begin in discussing it.
First of all, this book suggests an approach to retirement planning that is similar to Raymond J. Lucia’s Buckets of Money. I’ve read that book as well, but from my perspective of wanting to simulate things to see how they work for myself, I find Asset Dedication to provide a clearer framework. The many possible permutations and variations of Buckets of Money leave me a bit overwhelmed to know where to start testing it.
For those who are already familiar with Buckets of Money, a few differences in Asset Dedication include:
-The Asset Dedication authors do not like annuities [their opposition is based on fees built into annuities among other things... this is an area where I need to do more reading before I can have any opinion: financial professionals tend to either love or detest annuities and I don’t know who is right]
-Asset Dedication involves actually locking in future spending needs with specific bonds, whereas Buckets of Money allows for various bond mutual funds and other possibilities that do not specifically lock-in a spending goal
-Asset Dedication limits asset classes to stocks, bonds, and bills, which certainly is quite simplifying in comparison to the exotic possibilities of Buckets.
When I read Buckets of Money and Asset Dedication, the main issue that concerned me is that in some scenarios (though it doesn’t have to be this way, as I will explain), the stock allocation for retirees can creep up to 100% before shorter-term buckets are refilled / new assets are dedicated to short-term expenses.
Huxley and Burns are quite upfront about this issue, as they believe strongly in the “stocks for the long-run” idea that stocks provide superior performance for sufficiently long periods of time.
That makes me nervous. One thing is quite clear from the U.S. historical data though, which is that stocks have performed best. I’ve seen this time and again in my research. 100% stocks support higher maximum sustainable withdrawal rates, largest wealth accumulations at retirement, lowest safe savings rates, and so on. But before fully embracing the Asset Dedication approach, I do want to consider Monte Carlo simulations that allow for more scenarios to compare Asset Dedication to traditional asset allocation, in order to see how they perform in worst-case scenarios. The superior performance of Asset Dedication shouldn’t just happen because it has a higher stock allocation, but because there really is something meaningful going on with its differing approach to the asset allocation question.
I don’t have my answers about the Monte Carlo simulations yet, but I hope to look at it sometime. It is not perfectly straightforward, because I cannot just simulate total returns for stocks and bonds. I also need to simulate bond yields and the bond yield curve, because the whole purpose of buying bonds with Asset Dedication is to precisely lock-in future spending needs.
With all that background out of the way, let me now discuss how Asset Dedication works in relation to traditional asset allocation.
The authors are critical of traditional asset allocation, because other than saying that risk tolerant individuals can hold more stocks, there is no clear way to decide on the appropriate allocation between stocks, bonds, and bills. In asset allocation, bonds are treated as “stocks-lite”, in which a volatile bond mutual fund is held that still fluctuates in value, but just to a lesser degree than stocks. This approach is tied up too much in a sort of single period framework which abstracts away from an investor’s goals, which in this context is to build a nest egg that will allow for desired spending amounts in retirement up to age 100.
Short-term volatility shouldn’t matter except when it is time to start withdrawing funds from the portfolio. As such, Asset Dedication doesn’t call for using bonds to reduce portfolio fluctuations. Rather, bonds should just be used to lock-in future spending amounts as retirement approaches. Or, if one’s portfolio grows ahead of schedule and meets the wealth target goal early, bonds can also be used to lock-in the goal since further portfolio growth is not needed.
That’s the idea of Asset Dedication. Don’t treat bonds as stocks-lite. Use stocks to achieve portfolio growth and use bonds to lock-in spending amounts. What this typically means is that people should have a 100% stock allocation until they either reach their wealth goal or get close enough to retirement to lock-in some spending. Just a note, the authors encourage the use of an indexed mutual fund for stocks to save on fees and avoid active management. Only the minimal amount needed to lock-in spending should go to specific bonds, and the rest should be in the stock index fund.
To the extent that this provides an improvement over traditional asset allocation, it helps to devote as much as possible to growth assets, and it helps to avoid having to sell stocks after momentary drops, because nothing will need to be sold until it is time to lock-in more spending. Essentially, someone with greater risk aversion can lock-in a longer spending stream, which devotes more to bonds, and then allow the remaining stocks a longer time to compound before needing to be sold.
About the time horizon to lock-in spending, the book offers several possibilities. In each case, the authors discuss a 5 year span as a reasonable choice, but the span could be anywhere from 3 years to 10+ years depending on the risk aversion of the investor. Longer horizons will lock-in a longer period of spending and will increase the bond allocation, with the (potential) downside of reducing the stock allocation and decreasing the growth potential of the portfolio. The possibilities are:
1. Fixed horizon: Dedicate assets to cover the next 5 years. At the end of 5 years, start over and dedicate assets for the following 5 years after that. This approach doesn’t sound appealing to me, because this is the way you end up with 100% stocks at the end of each of these fixed horizons before you make the updates.
2. Rolling horizon: I like this one better. Start with a 5 year horizon, but at the end of each year sell enough stocks to buy a new 5-year bond to lock-in spending for another year. This keeps the planning horizon always at 5 years.
3. Flexible horizons: This just allows for more flexible to change the horizon depending on how stocks are performing or the level of interest rates, though be careful about getting involved with market timing when doing this. One good idea here is to lock in a longer period whenever stocks have performed particularly well. This would also help if you believe that market valuations affect subsequent stock returns, as it could help you avoid becoming too greedy as your portfolio grows beyond your goals.
One final comment: I really like the discussion in the book about “critical paths” to determine if the portfolio is on target. Comparing where it is now with where it needs to be to achieve one’s goals. I recently had a blog post in which I was doing something similar, and I think it is a great way to think about these problems. I think it would be interesting to investigate the interactions between how wealth targets are conceived in this book along with how I look at retirement goals in terms of the savings rate used rather than the wealth accumulation amount, in my “safe savings rates” paper.
I like this book a lot, and I do want to make some simulations based on it to be more confident about the approach. The authors do a great job making a convincing case for Asset Dedication instead of Asset Allocation, and I just want to see for myself that it is not too heavily reliant on “stocks for the long run” because all of its tests were based on historical data since 1926. So stay tuned...