Tuesday, June 25, 2013

Video Interview: Stephen Huxley and J. Brent Burns of Asset Dedication

As a part of developing curriculum for the RICP retirement income designation for financial advisors, the New York Life Center for Retirement Income at The American College has been building a vast library of free educational videos on its website. A few months back I included posts highlighting some of these videos [Curtis Cloke] [Colleen Jaconetti]. I'd like to get back to doing that more. Today, I will feature three videos of discussions with J Brent Burns and Stephen Huxley, the creators of Asset Dedication.

Huxley and Burns 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, bills, and other asset classes.  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 to secure a funding stream over their retirement.

This first video discusses the general concept of Asset Dedication as it relates to the three general retirement income approaches defined by the Financial Planning Association: total returns investing, time segmentation, and essentials vs. discretionary.  I would say that Asset Dedication has the most in common with time segmentation, as it is about dedicating assets to what they are best suited to do: bonds provide fixed income at specified dates, and stocks provide growth potential.

Video 1 [note to email readers: videos do not appear in the email, but you can link to the blog post to see them]

Here are some notes which highlight key points in the above video:

Retirees need to weigh the consequences between spending too much and spending too little, that is being too frugal or running out of assets.

The critical path links a planned lifetime spending pattern to where the portfolio should be at any point in time during retirement to achieve that objective. It's a starting point for figuring out if one is on track for a sustainable retirement. It is a way to benchmark market performance and investment returns to the retirement income plan. This is the type of benchmark needed in personal finance, not tracking investments to a benchmark such as the S&P 500.

Volatility is not an appropriate measure of risk for personal financial planning. When one is in the safety zone above the critical path, volatility may not be risky, but a low volatility portfolio may be quite dangerous when one has fallen below the critical path and the portfolio is plummeting toward zero.

With traditional asset allocation, different asset classes are mixed into a single portfolio, and individuals have a very difficult time relating to why they have a particular asset allocation or what the different parts of their portfolio are aiming to do. Bonds are used as a way to dampen volatility, which leaves them behaving as sluggish stocks.

Time segmentation can be more intuitive than the blender approach of the total returns portfolio, as it's easier for people to understand that certain assets are to be used for the short-term horizon, certain assets for the medium-term horizon and certain assets will be kept for long-term spending needs.

With the income floor approach, the idea is to first build safe and secure income for one's entire retirement planning horizon, and only after that can one begin to include more volatile assets which provide greater upside potential. As they note, especially with the low interest rates of today, building a lifetime floor can be very expensive to do and it is not practical or affordable for many people approaching retirement. This approach can protect you from destitution, but it may lock out any ability to enjoy the quality of life that people may really desire for their retirement.

Asset dedication is based on dedicated portfolio theory or liability driven investing, in which particular assets are matched to specific liabilities (spending needs) in retirement. Portfolios are immunized and duration matched so that no matter what happens with interest rates, the portfolio provides the planned cash flows.

Asset dedication has elements of all three retirement income planning approaches. It doesn't build an income floor, but it builds an income front end. The assumption is that people have not saved enough to immunize the entire lifetime of spending. Importantly it also accounts for the fact that spending needs may change, and so there needs to be some flexibility built into the retirement income approach. If your desired withdrawal rate is above the yield curve, you can't build a bond portfolio to meet your spending needs, and bonds would actually be serving as a drag on the portfolio as there will be no chance to get the types of returns needed to meet those lifetime spending goals. 

Equity exposure moves you away from the guarantee that your plan will work, but gives you a chance to meet your goals. By building an income floor at the front end of the portfolio, one has assets dedicated to meeting their spending needs over an eight year (or whatever length is chosen) horizon, and then the remainder of the portfolio is invested for long-term growth. Asset dedication is sort of like time segmentation because there are these two different time components, and it includes elements of a total returns perspective in that this is the investment strategy for the back end of the portfolio. Assets are dedicated to the purpose they are best suited for: bonds generate predictable cash flows and stocks are not predictable but provide growth potential. The approach also avoids short-term sequence of returns risk as the volatile assets will not need to be sold off directly after a market drop.

If you find Asset Dedication intriguing, the next two videos continue the discussion. Video 2 provides some examples and also describes historical backtests. Video 3 discusses some other intriguing concepts, such as the "equity yield curve."

Edit: I aimed to embed all three videos here, but there is some problem in which all three videos them point only to the last one. So instead, here is a link to video 2 and a link to video 3