Monday, October 29, 2012

“Adaptive Investing: A Responsive Approach to Managing Retirement Assets”

An interesting article in the new fall issue of the Retirement Management Journal is Sam Pittman and Rod Greenshields’ “Adaptive Investing: A Responsive Approach to Managing Retirement Assets.” Unfortunately, new issues of the journal are not available online, but you can seek a working paper version of their article here.

Both authors are from Russell Investments, and this article updates readers on the Russell Investments approach to retirement income which I introduced here back in April when reviewing the excellent, Someday Rich: Planning for Sustainable Tomorrows Today (Wiley Finance)

The Russell Investments approach is sufficiently important that it is worth re-visiting. They think in terms of three financial goals for retirement: a low risk of outliving assets, consistent income, and financial flexibility. Sustainability, Predictability, and Liquidity.

Funded Ratio Management

To meet these goals, Russell Investments suggests thinking in terms of funded ratio management, which may also be known to readers as asset-liability management or liability-driven investing.

First, a retiree calculates their assets as one total number. This includes the financial portfolio, as well as the present discounted value of other potential income sources, including Social Security, pensions, annuities, part-time work, etc.

Next, a retiree calculates their liabilities as one total number. This could include current debt such as a mortgage or loan balance, but mostly what we need here is the present value of lifetime spending needs.

Next, divide assets by liabilities. This is the funded ratio. If it is 1 (or 100%) then sufficient assets are available to cover liabilities. If it is greater than 1, a retiree enjoys the flexibility which comes with having more than needed. If it is less than 1, a retiree is underfunded. Options here include reducing spending plans, working longer, or making a Hail Mary pass and taking on more risk with one’s investments. Regarding the last point, Russell strongly discourages this, arguing instead that rather than taking a chance that the funded ratio will get even worse, retirees should plan to spend less and not add more risk.

Assets, liabilities, and the funded ratio will fluctuate over time in response to portfolio returns, interest rates, inflation, or unexpected spending needs.

Managing Longevity Risk: The Value of Delaying Annuitization

Retirees must deal with uncertainty about their longevity. They can insure this risk through annuitization. But annuitization reduces the flexibility goal for their assets. There will not be excess funds available for other purposes. So rather than annuitizing right away, Russell suggests avoiding annuitization for as long as possible but keeping it in the background as a potential option.

As long as the value of a retiree’s financial assets stays larger than the cost of annuitizing a desired lifetime remaining income stream, then there is no need to annuitize. But the option is still there.

In practical terms, they way they suggest to go about doing this is to set aside assets to cover spending needs over the next 10 years (updating each year to maintain a 10-year horizon). Then, manage remaining assets so that they retain sufficient value to buy an annuity to cover lifetime spending needs after the 10-year horizon. If the value of those assets start to drop below the value of the liabilities (represented as the cost of the annuity to fund those needs), then seriously consider buying an annuity, or come to terms with the idea of lowering future spending.

Adaptive Asset Allocation

One other aspect of the Russell Investments approach is to adjust asset allocation in response to changes in the funded ratio. This connects asset allocation to the liabilities which must be funded by those assets. The stock allocation should be the lowest when the funded ratio is 100%. As William Bernstein says, stop playing the game if you’ve already won. As the funded ratio increases above 100%, a higher stock allocation can be justified for the surplus assets which exceed liabilities. Again, as the funded ratio falls below 100% the mathematical solution is also to increase the stock allocation, but they suggest not to do this. Rather, reduce liabilities so that the available assets are sufficient without upping the risk.

By adjusting the asset allocation in this way, it should be possible to better protect oneself from seeing their funding ratio fall below 100%. But do be careful about taxes, trading costs, and portfolio turnover. I haven’t seen the math behind this part, but I do wonder about the implications that one is buying high and selling low when overfunded. I wonder if the asset return assumptions guiding this part of the analysis account for mean reversion or whether they are independent and identically distributed. Mean reversion would work the other way, suggesting to reduce the stock allocation as the overfunding level grows.

At any rate, the adaptive asset allocation part is about making marginal improvements to the outcomes. The heart of the material is thinking in terms of the asset-liability model and managing the option of delaying annuitization. Those are two important lessons to incorporate into a retirement income plan.