Allocate assets and products, and more kinds of them, wisely

Traditionally, asset-allocation referred to the proper combination of various financial investment asset-types in portfolios. A lot of research confirmed that the decisive factor of long term total portfolio returns, especially if taken together with volatility - that is the so called ‘risk-adjusted return’ - , is not how smartly or luckily one selects the individual building blocks of the portfolio, but how expertly this combination is determined and maintained, considering the specific role and circumstances of the portfolio. As a starter, people talk about cash, fixed income assets and equities as basic asset classes, … and many people stop there. Some use the term more broadly, by adding subcategories, or brand new ones, like currencies or commodities, etc. Others distinguish, in addition, financial vs. real vs. personal assets (where the latter is meant usually in terms of earning potential), … and emphasizing that balancing these is important as well. I prefer to address the issue even more broadly.

Recently, with more attention given to retirement planning and different characteristics of accumulation vs. depletion portfolios, a new concept has been elaborated and formalized. It’s an important step toward the broad life planning concept direction I espouse, so I’m quite pleased with this development. The essence of the new approach, targeted mainly for baby boomers, is that instead of asset-allocation what one should do is ‘product allocation’. By this it’s meant that, considering the specific needs and circumstances of, and the additional risks facing boomers, there is a challenge to balance various income generating assets in retirement portfolios. The balancing has to address

• inflation risks (that is the gradual erosion of purchasing power of the dollar, that has been and probably will be very significant on the long run at least)

• longevity risks (that is the big unknown factor of our life span; the income has to come from the portfolio for a potentially very long duration)

• investment risks, but in an additional sense as well, compared to the usual ‘what is the long term return’ question regarding accumulation portfolios. Namely, the so called ’sequence of returns’ aspect in depletion portfolios (mentioned in my Nov 2006 newsletter already) has to be taken into serious consideration

• liquidity needs that might arise because of unexpected developments, … most likely health care needs

• ability (and perhaps even willingness), or rather the lack of these to manage own financial matters, today and in the future

• intergenerational or estate considerations

Retirement income can come from various sources: pension plans of different kinds, social assistance programs, own investments in traditional investment portfolios of various volatility, annuities, and other guaranteed income products, … or even from rental or part-time work arrangements. The important novelty in this regard is the recent appearance of so-called Guaranteed Minimal Benefit Withdrawal (GMWB) plans in Canada. These are a kind of hybrids of annuities and segregated funds, guaranteeing income for life (if you want so, but fix term guarantees are available as well), while keeping the liquidity, and having the potential for growth if the investments within the plan perform well. There are currently six insurance companies offering GMWB plans. (Because of the longevity risk calculations involved, actuarial expertise of insurance companies is a prerequisite for creating such products.) There is no ‘best for everyone’ product or company amongst them, of course, … each has its strengths and weaknesses, and none is good enough from all the points of views that the challenges in the above list represent. To find out what kind of diversification among, or combination of them is preferable to someone, both the specific features of these products and the circumstances and preferences of the retiree have to be taken into consideration.

Unfortunately, like with many other useful things in the financial fields, companies tend to keep (in my judgment unnecessarily) too much - tools, sources, and information - unavailable to the wide public. As a consequence, I’m not entitled to link from here directly to the best learning tools regarding the product allocation concept. However, what you find on the somewhat product sale oriented
manulifeincomeplus.ca site is also quite informative regarding the challenges and the features of retirement planning and this special product. Similarly, you can learn a lot about the basics at Desjardins Financial Security’s public Helios website or at Empire Life’s Class Plus site as well. I intend to post more details and analysis of the GMWB plans in the future.

To use the diversification idea at an even higher level, it makes sense to think about insurance in an asset allocation sense, and from a planning perspective, or even consider the allocation of your time and attention to various parts of your life, financial and non-financial included. If you consciously include the potential for ‘non-linear developments’ in your life or in the world (various kinds of catastrophes mainly, … since the potential ‘lottery winning’ occurrences we’ll more likely be able to deal with somehow as they come), then talking about your survival and self-sustaining skills (that may save you money, bring more joy, or can be bartered, e.g.) and your physical assets and circumstances (location, land, tools, materials, etc.) as well as your relationships and health and fitness become serious issues at every stage of the lifespan, although somewhat differently for a 40 years old than for a 70 years old, naturally. If you want to achieve improvements in any of these regards, the related decisions and actions may have direct an immediate or delayed monetary consequences or demands as well. Thus, while carefully allocating three broad product categories in retirement portfolios (annuities, GMWB plans, and systematic withdrawal plans from traditional non-guaranteed investment portfolios) is important and certainly a step forward from the traditional cash+bonds+equities approach, it still may not be enough. In this broader sense, there is no way of making a calculator spit out a recommendation for us. Instead, we have to use various tools and approaches (VisionWorks, ORC, and Verne Wheelwright’s offerings, referred to in the previous two sections being quite useful for this exercise), and the decisions at the end will be very subjective and based on values and judgment. In a sense, it’s the open acknowledgement that while formalization and quantification of planning are useful and important, there are always limitations to them as well.

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After weeks of brooding, post was finally published on March 8, 2009