Good Time to Check Your Clients’ Funding Buckets

Including non-financial assets in the client’s asset allocation calculation

Many financial advisors fail to consider non-financial assets, such as Social Security, pension and annuity payments, when developing a client’s asset allocation strategy for their portfolio. However, if the client’s objective is to fund future essential expenses with non-risky assets, it is important to consider the client’s non-financial assets rather than simply use a rule of thumb – like the 60/40 allocation approach – and apply it to the client’s portfolio of financial assets.

The next section will outline a relatively simple process that compares the present value of a client’s essential expenses with the present value of their non-financial non-risky assets to produce a preliminary asset allocation strategy to apply to the client’s financial asset portfolio. Note that under the safety-first approach I recommend, I consider “floor plan” assets to be the same as “non-risky” assets.

For more information about this process and other recommended processes (and spreadsheets that facilitate the required present value calculations), see my website.

Calculation of preliminary asset allocation

The following five steps comprise my recommended process for determining a client’s preliminary asset allocation to be applied to their portfolio of financial assets (accumulated savings).

1. Determine essential expenses. These are the client’s expenses in retirement that they don’t want to reduce, if at all possible. These expenses can either be recurring (periodic expenses expected to last all or most of the client’s remaining lifetimes), or non-recurring (such as mortgage repayments expected to be paid off during retirement, pre-Medicare health insurance costs, long-term care costs, etc.). The categorization of these expenses may change from time to time depending on the client’s risk tolerance and other factors. The client may designate certain expenses to be partially essential and partially discretionary.
2. Calculate the present value of future essential expenses.
3. Determine non-risky assets/investments. These are assets or investments with little or no downside risk. As noted above, they include Social Security, pension and annuity payments, CDs, bond ladders, etc. The client may designate certain investments to be partially risky and partially non-risky.
4. Calculate the present value of non-financial floor portfolio (non-risky) assets.
5. Calculate the preliminary percentage of accumulated savings allocated to non-risky investments using the following formula:

For example, if

• The present value (PV) of the client’s essential expenses is $2,100,000;
• The PV of the client’s non-risky non-financial floor portfolio assets is $1,700,000; and
• The client’s accumulated savings (investment portfolio or nest egg) is $1,000,000,
• The percentage of accumulated savings allocated to non-risky investments under the above formula would be 40% ([$2,100,000 - $1,700,000] / $1,000,000) and
• The maximum percentage of accumulated savings allocated to risky investments used to fund discretionary expenses would therefore be 60 percent.

Note that under this example, if the $400,000 of the client’s accumulated savings were allocated to the non-risky asset bucket, the present value of the client’s non-risky assets would equal the present value of the client’s essential expenses ($2,100,000), and the non-risky asset bucket would be considered to be fully funded.

This preliminary allocation would be recalculated periodically to reflect actual experience, any changes in assumptions, and any changes in the client’s estimated essential expenses or non-financial assets.

There may be valid reasons for a client to increase (or decrease) their preliminary asset allocation to non-risky investments compared with the results determined using the formula described above. In this case, the household may consider actions such as reclassifying some of their expected discretionary expenses as essential expenses, deferring commencement of Social Security benefits, or working in part-time employment.

The preliminary asset allocation determined using the above approach is a data point used to start the asset allocation discussion and may be modified to reflect specific client goals, tolerance for risk and other preferences. Reflecting non-financial assets and comparing the present value of a household’s non-risky assets with the present value of client-selected essential expenses (and attempting to keep these items matched) will provide the client with important information regarding how conservative or aggressive their overall investment strategy is.

Actions to consider in light of recent stock runup

U.S. equities have experienced a healthy run-up in the recent past. Does this mean that households should automatically increase their investment allocation in non-risky investments (rebalance)? Not necessarily. In fact, just the opposite may be warranted. If the client’s non-risky assets fully fund the client’s essential expenses and the client is happy with how they have classified their essential expense spending, then there may be no compelling reason to allocate a greater percentage of the portfolio to non-risky assets.

Using the above example, let’s assume that the household’s accumulated savings has recently increased from $1,000,000 to $1,200,000 and there have been no other changes in the present values. The percentage to be allocated to non-risky investments under the formula would now be 33.33% ($2,100,000 - $1,700,000) / $1,200,000, not 40 percent. Note that while the allocation to non-risky investments decreased as a percentage of the total portfolio, the dollar amount allocated to the non-risky funding bucket remains at $400,000 in this example.

Clients who previously did not fully fund their essential expense liability may wish to consider doing so at this time in light of the recent equity run-up by investing more of their assets in non-risky investments. Clients who previously fully funded their essential expense liability but feel more comfortable at this time reclassifying more of their expenses as essential may also wish to consider investing more of their portfolio in non-risky investments.

Clients with a fully funded essential expense bucket and a significantly over-funded discretionary expense bucket may wish to consider increasing their discretionary expense spending at this time.

Summary

In light of the recent U.S. equity run-up, it will generally make sense to check the funded status of retired (or nearly retired) clients’ two funding buckets to see if changes in spending plans or investment strategy may be warranted at this time.

Ken Steiner is a retired actuary with a website titled "How Much Can I Afford to Spend in Retirement?"

A message from Advisor Perspectives and VettaFi: To learn more about this and other topics, check out our videos.

Read more articles by Ken Steiner