In the famous back and forth between Fitzgerald and Hemingway, Fitzgerald ran on at length about how the rich are different from you and me, and Hemingway cut it short with yes, they have more money.
Retirement is indeed different for most of us - we no longer have a job - and that changes everything. In time, we'll explore all the major implications this has, but for now, let's start at the beginning: When most of us leave the workforce, whether we realize it or not, we are shifting from the accumulation phase of our financial life to the distribution phase - from saving and investing to spending our savings.
Yale's David Swenson argues that asset allocation is responsible for most if not all of the variability of returns in a portfolio, with tax efficiency coming in ahead of stock picking and timing as much smaller factors.
Asset allocation, then, is perhaps the most important part of a savings and investing strategy. How does retirement - the change from the accumulation phase to the distribution phase - affect asset allocation?
Retirement Changes Everything
First, let's review what changes when we retire. The arc of our financial life starts with our personal balance sheet showing mostly human capital on the asset side of the balance sheet - our ability to earn a living - and a lifetime of living expenses on the liability side. During a working career, our human capital is slowly used up to pay living expenses with some amount held back and converted to financial capital - savings. Along the way, we also accumulate social capital, typically, future Social Security benefits and pensions, that we earn by being a productive and contributing member of society.
At retirement, we've pretty well used up all of our human capital. On the asset side of our balance sheet, we now have the financial capital we've accumulated over a lifetime and the social capital that we've accrued during our working career. On the liability side, that lifetime of expenses is greatly reduced but still stretches out possibly another 30 years. It turns out that those who have been productive enough to accumulate significant assets are also typically in above-average health with active, healthy lifestyles and good medical care, which statistically puts them on the other side of average life expectancy - well into their 80s or early 90s.
In a nutshell, retirement is different from life before retirement because you are no longer able to work your way out of trouble. You arrive at retirement with pretty much all the savings you're ever going to have. The human capital cavalry is not going to ride up and rescue you with a paycheck. And now you must manage your balance sheet so it will sustain your lifestyle for upwards of thirty years without significant hiccups and without paychecks and bonuses to cover the thin times - a tricky balancing act indeed. Now you know why it's called a balance sheet!
In retirement, your focus shifts from investments to lifestyle. From total return to lifetime sustainable income. Asset allocation is no longer just the narrow focus on investment assets such as stocks and bonds, but shifts to a broad consideration of all of the assets on your balance sheet - human capital (income from any work in retirement), social capital (Social Security and pensions), the value or income derived from fixed assets (such as rental property or a closely held business) and physical capital such as home equity or valuable collectibles. Financial advisors who have just a narrow view of investments are less useful when you need to consider the long-term tax and survivor impact of Social Security and pension-claiming strategies, the tax advantages of QLACs, retirement tax efficiency and hedging long-term-care expense risk.
It's no longer Charles Ellis's simple question if you've won the game, why do you keep playing, but a realization that if you are going to have a successful outcome in retirement, the investment game is essentially over and now you are in a new game with new rules. Even the very successful with many millions in savings can lose the new game if they play by the old rules.
Retirement Risk Management
Asset allocation remains critical in retirement, but it broadens out to encompass all the household assets. With this broadening, we also utilize the full spectrum of risk management methods to allocate risk across the balance sheet. During the accumulation phase, the primary risk management technique is diversification to manage the risk you retain by investing in risky financial markets.
Even the very wealthy need more than diversification to protect their lifestyle from the various other risks that come to bear when employment and paychecks end and we are left with just our savings. The diversification of business risk in the market, which still leaves you fully exposed to market risk, is not enough to secure your retirement income for a period that could last longer than your working career.
RMA®s (Retirement Management Analyst®) use a planning framework to allocate balance sheet assets to four different risk management techniques - diversification, hedging, pooling, and avoidance. These techniques are used to manage four different portfolios - Upside, Floor, Longevity and Reserves portfolios - each designed to mitigate a different set of risks. RMAs call these the Retirement Allocations.
The allocation of capital to these portfolios comes directly for our own specific household balance sheet, not from generalized risk tolerance quizzes that attempt to assign our changing feelings about risk to some target asset allocation. Today you feel "moderately aggressive," but what about tomorrow when concerns at your job are multiplied by bad headlines, and you slip from "conservative" to "moderately panic-stricken?"
Upside, Floor, Longevity and Reserves Portfolios
On your household balance sheet, we subtract the discounted present value of your human capital (all future earnings from work) and social capital (Social Security benefits and pension payments) from the present value of all of your expected future expenses and liabilities. This leaves the amount of your living expenses that must come from savings. We call this the Floor. We also set aside 1-2 years of annual expenses as Reserves. When the Floor and Reserves are subtracted from your financial capital (your savings), what's left over is your Upside.
Upside is the amount of your savings that can be exposed to market risk without jeopardizing your lifestyle. We manage this retained risk by diversifying away business risk by holding a global market portfolio of stocks. This allocation comes right off your balance sheet, no quiz required. Since it's above your Floor, it is a sleep-at-night approach to using the market to support your goals rather than a Hail Mary effort to beat the market and juice up a failing retirement savings plan. We can think of Upside as your legacy or aspirational portfolio, nice to have, but life will be just fine without it.
Managing Upside is easy and low-cost, and can be implemented with just a handful of ETF funds. We're not concerned about the allocation of stocks and bonds within the Upside portfolio - it's 100% Upside, 100% stocks. What is strategically critical, however, is that the Upside allocation itself comes from your household balance sheet, not from generalized formulas that do not account for your household risk exposures.
Floor is the core of your savings needed to support your lifestyle throughout retirement. For most of us, this is an absolutely, positively has to be there item, not something we want to gamble with. So we manage Floor by hedging risk, investing in securities where the returns are baked in upfront and risk-free or guaranteed. Since lifestyle is heavily impacted by inflation, Floor should hedge inflation as well. The ideal Floor strategy is a ladder of TIPS (Treasury Inflation Protected Securities) bonds held to maturity, sized to cover the expected future expenses in the year each bond matures.
TIPS are "risk-free" Treasuries, and while it may not seem that important in this time of historic low rates and low inflation, they pay a modest real return above inflation, no matter how high inflation rises over the retirement period. They hedge credit, interest and inflation risk, the perfect trifecta for Floor. Floor is your lifestyle portfolio.
Ideally, you'd want to start building the ladder 10+ years from retirement, buying more cheaply 10+ years out on the yield curve, and arriving at retirement with your first 10+ years of retirement already funded. A ladder of Treasury STRIPS also make a solid Floor, and a combination of TIPS and STRIPS will give you a nominal hedge against the real return from TIPS.
Reserves is the ready cash you need to pay your everyday bills plus a reserve of cash for the unexpected. We manage Reserves by avoiding market risk and holding cash - but not so much cash that we expose Reserves to significant inflation risk. The longer end of Reserves can be held in a short rolling CD ladder. Depending on your unique household risk exposures, you may need more or less cash in reserve, but generally, 1-2 years of the amount needed from savings to cover annual expenses is sufficient. Reserves is your liquidity portfolio.
Longevity is a special case of Floor dedicated to managing longevity risk through risk pooling in insurance contracts. Immediate or deferred income annuities and QLACs are used to mitigate longevity risk. The Longevity allocation is carved out of the Floor allocation depending on the severity of your household longevity exposure. Keep in mind that well-educated, affluent couples who enjoy good medical care and healthy lifestyles are exposed to significant longevity (and long-term-care) risk. The longevity portfolio provides a Floor of income that cannot be outlived.
While asset allocation is even more strategically significant in retirement than it is during the accumulation phase, retirement phase asset allocation is much broader than the one-dimensional asset allocation used to implement an accumulation investment portfolio.
To set up a successful retirement phase outcome, we map household risk exposures to the household balance sheet, creating retirement allocations to Upside, Floor, Longevity and Reserves portfolios. RMAs call this the Retirement Policy Statement (RPS), the retiree's expanded version of an investment policy statement.
For a retiree, much more than peace of mind is at stake knowing that their retirement plan is based on the strength of their own household balance sheet and not on the results of a simple quiz about their feelings about risk and an investment manager's recommendations. Retirement income must flow every day of every year, not just when we have good feelings about the stock market!
I'll be discussing these ideas and many more in greater depth in this space, which is devoted to understanding the retirement phase and making the right decisions to achieve the successful outcome of a fully sustainable retirement.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: RMA®, Retirement Management Analys®t, The Retirement Allocations, and Retirement Policy Statement are trademarks of the Retirement Income Industry Association® (http://riia-usa.org). I am an independent financial planner/advisor who uses the RMA method.