Sunday, April 1, 2012

Russell Investments Personal Asset Liability Model

I’m back in Tokyo after productive trips to both Chicago and Los Angeles. I hope to get back to a regular posting schedule now, as I’ve got a growing backlog of things to discuss.
Another individual I had a chance to talk with at the RIIA conference in Chicago is Sam Pittman of Russell Investments. Earlier, he shared a book with me written by two of his colleagues, Timothy Noonan and Matt Smith. This book is Someday Rich: Planning for Sustainable Tomorrows Today.
I’m most of the way through reading this book and it is quite interesting. It is a book written for advisors, but it can be read by pretty much anyone. I think people considering hiring an advisor could especially benefit as well to help improve the overall client-advisor process. The book covers two main topics: how to become a better advisor and also how their Personal Asset Liability Model works.
Though the sections on how to become a better advisor do inspire me to want to become an advisor some day, I am not currently one. So for now, I will focus on their Personal Asset Liability Model. This is another example of a comprehensive retirement income strategy framework to help decide on an asset allocation and a product allocation. Their approach does share some features of the Dimensional Retirement approach I recently described, but it has one very major difference. That is, Russell Investments focuses on the real option value of waiting as long as possible to annuitize, recognizing, among other matters, that people are loath to give up control of their assets. The purchase of a single-premium immediate annuity exists as an important last resort solution to be avoided for as long as possible. Until then, systematic withdrawals guide the way, and Sam Pittman contributed a very innovative subsection to the book about how to choose a sustainable withdrawal rate.
The main idea of the Personal Asset Liability Model is to treat personal retirement planning in the same sort of way as a corporate pension fund. They focus on an individual’s funded status. Funded status of 100% means that a person has just enough assets to meet their liabilities, while overfunded and underfunded individuals have more or less than this, respectively.
Assets are the resources you have available to fund your retirement and liabilities are your planned retirement expenditures.
More specifically, assets include both the current value of one’s financial assets, and for pre-retirees, the present discounted value of one’s human capital. This human capital is the sum of all your expected future annual salary amounts multiplied by your planned savings rates for each of those amounts, and discounted by an interest rate that appropriately reflects the risk of those future salary amounts.
Meanwhile, liabilities are the total discounted present value of an individual’s essential retirement expenditures over the rest of their life adjusted for both inflation and survival probabilities to each age. The discounting for these future expenditures are the zero-coupon Treasury bond strips that have the same maturity date as each of the annual expenditure amounts.
This model can be used during both the pre-retirement and post-retirement periods to know if one is on track for a sustainable retirement. (Side note: an article I published in the October 2011 Journal of Financial Planning explains a completely different approach to determine if one is on track for a sustainable retirement). Being on track means that one’s available assets are at least as large as the planned liabilities.
If one is underfunded for retirement, potential solutions include working longer (increased human capital and decreased liabilities), saving more (increased human capital), or planning to spend less in retirement (decreased liabilities). Another option is to take more investment risk, but that could backfire if the portfolio drops further. Nonetheless, while Zvi Bodie’s safety-first approach is deadset against the investment risk option, these authors are not as sanguine about completely eliminating the possibility of rolling the dice with a risky investment strategy.
When those other options are no longer available and retirement is already underway, then falling to the funded status means that one should seriously consider about annuitizing in order to lock-in a floor of sustainable income that will meet one’s basic needs and last for the remainder of one’s life. This eliminates the possibility for any further upside, but at least it prevents further tragedy if one’s investment portfolio continues to drop.
Being funded does require monitoring carefully about the evolving costs of annuitization and the value of assets and liabilities. But careful investment planning does help to smooth some of the volatility. For instance, if interest rates increase, then the value of assets will decrease, the value of liabilities will decrease, and the cost of annuitization will decrease. Things move in tandem.  The co-movements can be quite precise when duration matching for assets and liabilities is used. Let me come back one of these days to explain more about the concept of duration matching, because it is quite important for retirees trying to match assets to liabilities.
A drop in the stock market could reduce one’s assets without affecting the liabilities or annuity cost though. Being funded does also require monitoring one’s spending habits. If spending increases and a higher lifestyle floor is desired, then this increases one’s liabilities and will reduce the funded status.
In their framework, financial security means having enough assets to annuitize and create a sustainable lifestyle floor for as long as one lives. This helps reduce the impacts from the uncertainties about how long one might end up living and about what will happen in the financial markets. Anxiety about retirement can be lessened, as barring a major black swan, lifestyle sustainability can be maintained for as long as one lives with this annuitization solution kept in the background.
And so, failure in this framework is not about running out of money. Rather, it is about letting your funded status fall below 100% and not being able to build it back up so that you can no longer afford your lifestyle floor.
Investment planning still plays a role, and they describe an adaptive asset allocation approach that relates both to the funded status and to one’s comfort with volatile investment strategies. They are basically describing a form of portfolio insurance in which investment risk is allowed to increase as the funded status increases. I will describe more about that at another time.
I must say that this framework makes a lot of sense to me. I definitely like the idea of defining failure as not being able to annuitize one’s essential needs rather than as completely running out of money. This book provides another important piece of the puzzle for how to build effective retirement income strategies.


Update:  Joe Tomlinson offered the following comment and since it includes a table, I'm adding it up here. From Joe Tomlinson:


SPIA Attractiveness and Age

This chart provides an age-based comparison of a couple of factors that may affect the attractiveness of purchasing a SPIA. In the left-side portion of the chart, I try something a bit more sophisticated than comparing the SPIA rate to current interest rates. Instead, I make the comparison to holding fixed income investments and taking a withdrawal rate that will be safe 90% of the time (i.e., there's only a 10% chance of living longer than the money will last). It's interesting to note that ratio of the SPIA payout rate to this safe withdrawal rate increases with age of purchase. So, based on this, the SPIA purchase becomes a more attractive proposition at older ages. 

SPIA Test






Age
SPIA Payout Rate
10% Survival Duration
90% Safe Withdrawal
Ratio
LTC Incidence
Times Age 65
65
5.96%
33.58
4.25%
1.40
.2%
1.0 times
75
8.51%
24.50
5.31%
1.60
1.24%
6.2 times
85
13.96%
15.75
7.55%
1.85
5.16%
25.8 times

However, there is another consideration that works in the opposite direction. A concern for elderly people contemplating a SPIA purchase is that they risk suffering an adverse health event that shortens their life expectancy, and brings increased financial demands that cannot be met with SPIA income. The right-side of the chart illustrates this based on the proxy measure of LTC claim incidence by age. This risk will likely weigh much more heavily on the mind as one ages.