The lost world of asset allocation–part 2, the liability profile

This post is in response to a recent article by Rob Carrick on “conventional” asset allocation approaches, titled Longer lives, new investing approaches. It commented on asset allocation rules of thumb to give you your equity allocation and bond allocations.

The trouble is these rules of thumb are meaningless in terms of deriving optimal asset allocations.  How you construct a portfolio should depend on a number of things.  One of the most important determinants of of asset allocation is the liability profile, which in layman’s terms is income and capital needs as a % of the portfolio value.

For a given set of risk premiums (returns on risky assets over lower risk assets), the factor with the biggest impact on asset allocation is the liability profile (net expenditure needs to be taken from the portfolio over time): this is the short and long term ratio of financial demands on the portfolio to the total value of the portfolio and it has relevance and impact.

In modelling terms it is a yield and is the net of all inflows to the portfolio and all outflows from the portfolio. 

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This ratio both influences and is impacted by portfolio structure, and is more or less significant depending on the risk and return assumptions used in your modelling – use too high a return assumption and you may not pick up the liability risks.

Indeed, assuming conservative return assumptions, the ratio for most individuals who are drawing down on capital is likely to rise throughout retirement to the point that eventually all capital would need to be in lower risk higher yielding assets, and in most cases, almost certainly annuities.  

Simple rules of thumb (e.g. 120 less age) are unable to deal with the significant differences in liability profiles and the changes in liability profiles that occur naturally through an individual’s lifetime.  

If liabilities can be comfortably met from yield alone (without having to overly stretch for yield), then withdrawals to meet liabilities are unlikely to be impacted by negative price movements (systematic risks such as inflation, market crashes, corrections, bear markets and specific security risks), and likewise the capital value of the portfolio will be less exposed to volatility and significant risk events.  Your assets can bounce around in value all they want if you are not having to sell them for consumption.  Over the short term, factors such as the real growth rate of the income stream remain important but have less immediate impact.

However, if portfolio structure is overly influenced by a need to meet financial needs from yield alone, this can skew a portfolio to lower risk/lower capital return asset classes, which may limit return opportunities. Indeed, if you are not modelling the risks of structure and liabilities, what you might find is that portfolio structures overly focussed on meeting immediate yield are not so good at meeting future inflation adjusted financial demands.  In other words, they may meet present needs from yield, but as time goes by yield alone will become insufficient and the portfolio may have depreciated to the point that it is no longer able to meet present and future needs even if all capital were to be consumed.

The lower the ratio (financial needs/capital) the less the need for lower risk assets that are specifically there to manage withdrawal risk and to provide yield, as opposed to provide return and diversification.

As an asset manager you may have an investment and a valuation discipline that recommends a central allocation to specific asset classes and markets on an asset only basis. This is the optimal allocation based on your world view of risk and return and your investment discipline and may be considered suitable for a narrow range of liability profiles.  It is this allocation which would need to be adjusted for higher yield requirements or variations in risk and performance preferences.  

A higher liability profile would adjust the low risk allocation upwards as the financial demands on the portfolio increases and/or increase the allocation to higher yielding and more defensive risky assets.

An 80 year old with a 1% yield requirement would not need an 80% bond allocation (100-80=20) while an 80 year old a much higher yield requirement may find themselves wholly invested in bonds and annuities.   How and why the capital consumption is managed through portfolio construction planning and management is discussed later.

The less you know of the process, or the less you can resource, the simpler it should become, the lower the cost of the exercise – rules of thumb allocations should cost next to nothing to implement. But they don’t always.

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