Asset allocation within "Flooring" portfolio

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Asset allocation within "Flooring" portfolio

Postby JamesG » Sat May 04, 2013 8:52 pm

Hello,

Firstly, thank you for this great site. I have been reading it for many months, but this is my first post.

I recently read Zwecher's "Retirement Portfolios". I was led to this book in my effort to better understand Bill Bernstein's recent references to "liability matching portfolios". I found myself attracted to the flooring idea, even if only because it is the first time I have seen a logical rule that provides a rational basis for something approaching the "age in bonds" dictum.

I would welcome thoughts and discussion on what should be the asset allocation within the "flooring" component of a portfolio? I think inflation-protected securities should figure prominently, but I am guessing that it would be wise to also include allocations to other low-risk assets, not only to spread risk, but also to pick up small gains from periodic rebalancing. At the same time, I recognise that movement away from the inflation-protected allocation erodes the essential low-risk characteristic that defines a "flooring" portfolio.

I am toying with an allocation along the following lines:

45% Inflation-protected government bonds
35% Standard nominal government bonds
15% Corporate bonds
5% Cash

I would aim to hold these in a low cost way - Vanguard ETFs/mutual funds, and my tax-favoured superannuation fund.

Thank you very much for your thoughts.
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Re: Asset allocation within "Flooring" portfolio

Postby bobcat2 » Sat May 04, 2013 10:58 pm

Pick the floor level of real income you want your portfolio to provide in retirement. See how much a real life annuity (real SPIA) for that much annual real income costs today at your future retirement age for your gender. That is your estimate of how much safe assets you need at retirement. Calculate how much you will need to save in additional safe assets (in addition to the safe assets you already hold) between now and retirement to reach that level of total safe assets at retirement. Re-estimate at least once a year. If you are falling short of your goal of safe assets at retirement at some point save more, retire later, turn some of your risky assets into safe assets, or lower your safe income goal.

Safe income for retirement needs to be inflation protected. So the safe assets you are holding before retirement are I-bonds, TIPS bonds, and TIPS bond funds. As you near retirement the only TIPS bond funds you should be holding are ST.

BobK
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Re: Asset allocation within "Flooring" portfolio

Postby JamesG » Sat May 04, 2013 11:30 pm

Dear BobK,

Thank you very much for your reply.

I will think carefully about your first paragraph. My wife and I are 44, and planning to work another twenty+ years. Our plan is, each year to age 65, to put aside the present value of the year t+20 consumption "flooring". With post-tax real returns on bonds slightly negative, this means putting aside today more than the year t+20 real consumption requirement. Thinking about your first paragraph, I see that our plan is deficient in only providing flooring to age 85. Your plan (annuity) handles the post 85 component. This looks sensible, and I will think more carefully about accumulating the annuity.

Thank you for your second paragraph. You affirm the value of inflation protection in the flooring portfolio. I agree. I was not very comfortable with the large nominal component in the allocation I initially suggested.

Cheers,
James
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Re: Asset allocation within "Flooring" portfolio

Postby bobcat2 » Sat May 04, 2013 11:51 pm

Just to be clear, I am not saying you have to buy a real life annuity at your retirement age. But I am saying that is the best way to price how much in safe assets you need at retirement to fund a given safe floor of retirement income, is to use the price of a real life annuity at your retirement age and adjust each year as that price fluctuates over time, primarily due to changes in real interest rates and changes in longevity at your retirement age.

For instance, you could fund part of your safe floor income in retirement by purchasing a life annuity at retirement and spend out of your remaining safe assets up to the floor level each year. As you age, and hopefully remain healthy, you can purchase further annuitized income.

BobK
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Re: Asset allocation within "Flooring" portfolio

Postby JamesG » Sun May 05, 2013 12:21 am

Dear BobK,

Thank you for the clarification. I like your suggestion of targetting, for flooring purposes, steady accumulation of the price of an annuity at retirement. I understand that the argument does not presume eventual purchase of an annuity.

I might ring my superannuation fund on Monday and ask if they can help me with a back-of-the-envelope estimate of an age-65 annuity price.

Cheers,
James
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Re: Asset allocation within "Flooring" portfolio

Postby bobcat2 » Sun May 05, 2013 8:41 am

You can check out the price of real life annuities online at the Income Solutions platform at Vanguard.

Link to Income Solutions platform at Vanguard.
https://investor.vanguard.com/what-we-offer/annuities/get-guaranteed-income

Sad but true - if you want safe income in retirement you have to invest in safe assets before retirement to get there. :( You have only one retirement portfolio, but within that one portfolio two goals and a separate strategy for each goal. One strategy is to achieve a safe retirement floor income at retirement. That strategy is funded with safe assets. The other strategy is to achieve your aspirational level of retirement income above the floor. This is funded with a combination of diversified risky and safe assets. If the risky assets do better than expected, some of those risky assets can be converted to safe assets and you can raise the safe income floor.

BobK
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Re: Asset allocation within "Flooring" portfolio

Postby JamesG » Mon May 06, 2013 7:54 am

Thank you for your insights. You state the problem very clearly: two goals require two instruments.

The price of an Australian joint life annuity proved as high as I feared: $0.5m. for a real annual $20.4k. I guess this is not surprising, with real interest rates at approximately 0%. It turns out that using the annuity price as our age-65 target proves a little more expensive (approx 10%) than our initial estimate (based on accumulating a twenty year floor by age 65). Either way, I see the value of having a plan and sticky with it - we will just have to live with the reality of low real interest rates and make our plans accordingly.

You raise an interesting philosophical question in your second paragraph: that is, how should one think about arriving at a value for the "safe" asset proportion in the aspirational portfolio? Without having yet given it much thought, I would have assumed that the aspirational portfolio should have a very high equity orientation. With low-return inflation-protected securities doing so much heavy lifting in the flooring portfolio, I think I will struggle with the idea of allocating much more than about 10% of the aspirational portfolio to bonds (and this only to pick up some rebalancing gains). I guess this question can only be answered by an introspective assessment of one's own risk preferences, and a realistic evaluation of one's likely resources at retirement: perhaps the higher one sets the level of flooring income, the lower should be the bond allocation in the aspirational portfolio; likewise, the higher one's likely assets at retirement, the lower can be the bond allocation in the aspirational portfolio.
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Re: Asset allocation within "Flooring" portfolio

Postby bobcat2 » Mon May 06, 2013 10:09 am

JamesG wrote:"You state the problem very clearly: two goals require two instruments.

You raise an interesting philosophical question in your second paragraph: that is, how should one think about arriving at a value for the "safe" asset proportion in the aspirational portfolio? Without having yet given it much thought, I would have assumed that the aspirational portfolio should have a very high equity orientation. With low-return inflation-protected securities doing so much heavy lifting in the flooring portfolio, I think I will struggle with the idea of allocating much more than about 10% of the aspirational portfolio to bonds (and this only to pick up some rebalancing gains). I guess this question can only be answered by an introspective assessment of one's own risk preferences, and a realistic evaluation of one's likely resources at retirement: perhaps the higher one sets the level of flooring income, the lower should be the bond allocation in the aspirational portfolio; likewise, the higher one's likely assets at retirement, the lower can be the bond allocation in the aspirational portfolio.


There is only one portfolio in life-cycle investing, but there are two retirement income strategies. One is matching for the floor and the other is a diversified strategy to get from the floor income to the aspirational level of income. This distinction between strategies and portfolios is important, because typically if the diversified portion of the portfolio does well one transfers assets and raises the safe floor nearer to the aspirational income level. One does not keep the floor and redefine the aspirational level up. Conversely, if the diversified portion of the portfolio does poorly, you keep the safe floor but choose some combination of the following options with regard to the diversified portion - save more, retire later, take more risk, or lower the aspirational retirement income goal. Unfortunately, each of these four options has a downside, which is a key reason you want a truly safe floor strategy in addition to the diversified assets in the portfolio.

In life-cycle investing one is serious about meeting the goals set. For retirement we set floor and aspirational levels of income and intend to meet those goals. If one sets the risk level very high in the asset allocation for the aspirational level of retirement income then you have a good chance of exceeding your aspirational level of retirement income, but if you set the risk level lower to have a high probability of hitting the goal but not much chance of exceeding it by very much, your chances of hitting or exceeding the goal are greater than with the higher risk asset allocation.

The upside of taking a lot of risk in the asset allocation (AA) for getting to your aspirational retirement income goal is that that you have a good chance of exceeding the goal - sometimes by a large amount. The downside is the extra risk means you have less chance of meeting or exceeding your goal and your chances of falling far short of your goal are increased.

The above is easiest to see with a stylized simple example. With one year to go before retirement your portfolio is 2% short of of the target portfolio level. Safe assets have real interest rates of 2.7%. Your intended savings for the year is 0.3% of the current portfolio size. Which AA gives you a greater chance of meeting or slightly exceeding or slightly falling short of your goal - one hundred percent safe assets or 50/50 risky assets-safe assets. Which AA gives you a greater chance of exceeding your goal by a significant amount? Which AA gives you a greater chance of falling far short of your goal?

All of the above is not as conservative as it may sound. When you are many years from retirement the AA for the aspirational retirement income will likely be very high, perhaps 100%, partially because you have a large amount of implicit safe assets in the expected future contributions you, and probably your employer, will be making to your retirement income. These implicit safe assets include future contributions to Social Security and DB pensions as well as your own retirement portfolio. However, as you approach retirement you will want to stay on track for meeting your goal without taking excessive risk in your portfolio, because too much risk will lower the probability of meeting the goal. In addition those implicit safe assets of expected future contributions will be greatly diminished as your near your retirement date.

BobK
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Re: Asset allocation within "Flooring" portfolio

Postby JamesG » Fri May 10, 2013 6:23 am

Thank you again for your explanations. I have found them very helpful. You lay out the problem with textbook clarity, and I am very grateful. I think I now better understand the relationship between the flooring and aspirational portfolio components. I think I now also better understand the main role for a positive weight for safe assets in the aspirational component, namely, to narrow the dispersion of expected possible portfolio outcomes at retirement age.
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Re: Asset allocation within "Flooring" portfolio

Postby bertilak » Fri May 10, 2013 8:22 am

BobK,

A question re using the cost of an annuity as a benchmark for how much you need in safe assets. (Or is that in any assets that will eventually be converted to safe assets?)

An SPIA pays a bit more than other safe assets because of mortality credits (or because the insurance company keeps what's left of your premium at death, same thing said in another way). If you use the SPIA cost to estimate how much you need to target as your portfolio value might you come up a bit short since none of your non-SPIA investments can be expected to provide quite the level of income as an SPIA? More importantly, those non-SPIA assets are volatile so there is a chance you will not meet your target. I think one might need to aim a bit higher than SPIA costs to a) more likely meet your target and b) have an adequate target.

Of course the overall uncertainties may make my above thoughts below the noise level. Or, maybe that noise is all the more reason to aim a little high.
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Re: Asset allocation within "Flooring" portfolio

Postby Faith20879 » Fri May 10, 2013 9:08 am

HI JamesG,

Welcome to the forum.

Reading that you are 20+ years from retirement and that you are intrigued by the flooring concept, it reminded me of another option that might also interest you. It is the Treasury savings bonds route. Mel, a well-respected contributor here, once illustrated how one can use EE-Bonds (or I-Bonds) to build a floor for someone who has a 20+ horizon. It works like this, say your floor is 1,000/month * 12, you purchase that amount each year for 20 years. The initial EE-Bonds pay near zero interest but at the 20th year it's value doubles. So you are guaranteed to have that much each year. If you search "Mel EE bond" you'll find a lot of references.

Remember it is never an “all or nothing”. You can do a little bit of all your options.

Regards,
Faith
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Re: Asset allocation within "Flooring" portfolio

Postby bertilak » Fri May 10, 2013 9:17 am

Faith20879 wrote:HI JamesG,

Welcome to the forum.

Reading that you are 20+ years from retirement and that you are intrigued by the flooring concept, it reminded me of another option that might also interest you. It is the Treasury savings bonds route. Mel, a well-respected contributor here, once illustrated how one can use EE-Bonds (or I-Bonds) to build a floor for someone who has a 20+ horizon. It works like this, say your floor is 1,000/month * 12, you purchase that amount each year for 20 years. The initial EE-Bonds pay near zero interest but at the 20th year it's value doubles. So you are guaranteed to have that much each year. If you search "Mel EE bond" you'll find a lot of references.

Remember it is never an “all or nothing”. You can do a little bit of all your options.

Regards,
Faith

Being recently retired, I wish I had thought of that 20 years ago myself.
No-one really listens to anyone else, and if you try it sometime you will see why. | -- Mignon McLaughlin
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Re: Asset allocation within "Flooring" portfolio

Postby bobcat2 » Fri May 10, 2013 10:46 am

bertilak wrote:A question re using the cost of an annuity as a benchmark for how much you need in safe assets. (Or is that in any assets that will eventually be converted to safe assets?)

An SPIA pays a bit more than other safe assets because of mortality credits (or because the insurance company keeps what's left of your premium at death, same thing said in another way). If you use the SPIA cost to estimate how much you need to target as your portfolio value might you come up a bit short since none of your non-SPIA investments can be expected to provide quite the level of income as an SPIA? More importantly, those non-SPIA assets are volatile so there is a chance you will not meet your target. I think one might need to aim a bit higher than SPIA costs to a) more likely meet your target and b) have an adequate target.

Of course the overall uncertainties may make my above thoughts below the noise level. Or, maybe that noise is all the more reason to aim a little high.


Yes, you could think of the SPIA price as the minimum required for the safe floor. The reason for picking the price of a real SPIA is it adjusts over time for changes in real interest rates, changes in longevity at the retirement age, and inflation. In another words, a real retirement income target before retirement (in terms of wealth at retirement) is a moving target and the real SPIA price target accounts for the moves. If instead you were to pick a real wealth target at retirement it is difficult to account for changes in real interest rates and longevity. If you were to pick the price of a nominal SPIA it would not account for inflation. The rules of thumb people often use to convert wealth at retirement, such as wealth 25 times greater than retirement income, most certainly don't account for changes in longevity and real interest rates. They don't even account for your retirement age or your gender.

The other factor in using the price of the real life annuity is that the safe retirement floor needs to be safe. Therefore it consists of Social Security, real life annuity or annuites, DB pension, I-bonds, and TIPS ladders. So the distance between the real SPIA price and the amount needed for the safe floor that comes from your portfolio shouldn't be very large.

The price of the real life annuity is also used to target the aspirational level of retirement income. There it is truly a minimum and one needs to consider how much slack you want to factor in.

When you are investing for the safe floor before retirement you are investing in safe assets. Those assets can be converted to other safe assets at retirement. Investing in risky assets before retirement for your safe retirement income floor defeats the purpose of having a goal of a safe floor of retirement income. :happy

By picking the real SPIA target level of wealth you can see over time fairly accurately if you are coming up short in meeting your retirement income goals (aspirational and floor) and deciding how to account for that. Options are available such as saving more, retiring later, taking more risk, working PT in retirement, delaying SS and pension benefits, annuitizing more income, and using housing wealth by downsizing, reverse mortgage, etc. If you instead pick a wealth target it is difficult to discern if you are on track to meet your retirement income goal, and if you are off, how much adjustment needs to be made.

BobK
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Re: Asset allocation within "Flooring" portfolio

Postby rr2 » Fri May 10, 2013 12:58 pm

We are approaching our mid 40s as well. I have been reading Zwecher's book as well and am intrigued by it. My main problem is that so much is unpredictable and there are many scenarios. The biggest variable is the amount of social security income we will get at age 70. This can provide a significant part of the required flooring.
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