It is surprisingly easy to forget that your clients' investments exist to fund their lifestyles. Clients pull money from their portfolios to pay for living expenses, contribute to college costs, donate to charities and fund estate plans. They may not know exactly when all these outflows will occur, but they have a sense of the time horizons involved. The real benchmark for them, therefore, is whether their money can support their financial goals.
The problem with traditional asset allocation is that it uses formulas that are often removed from how clients think about their money and when they will need it. Model portfolios regularly fail to distinguish between clients whose monetary characteristics appear to be similar, but whose needs differ. This can be true for institutional as well as individual clients.
There is a better way. The asset-dedication approach allows advisors to create investment strategies driven by client goals. Like a pension manager, an asset-dedicating advisor will match cash flow to projected liabilities.
How It Works
The asset-dedication process starts by estimating a client's future cash flow stream. It then designs portfolios by matching investments to those cash flows. Short to intermediate fixed-income instruments are calibrated to provide predictable income over a period that makes the client comfortable, usually five to 10 years. Stocks and other growth-oriented investments cover longer-term needs. The advisor and client regularly reevaluate the investment strategy to reflect changes in income needs, risk perception and assumptions about the future.
To link investments effectively to cash flows, asset-dedication portfolios are broken into three subportfolios. The Cash Portfolio uses a money market account to fund income needs for the current year. The Income Portfolio uses individual bonds to meet clients' intermediate-term income needs. The Growth Portfolio, comprised of stocks and other high-return investments, generates returns for the long term. Growth Portfolio assets are sold as needed to replenish the Income Portfolio.
Asset dedication differs in several ways from traditional asset allocation. First, you'll find no fixed-formula "model portfolios." Instead, each portfolio is customized. Clients can adjust their time horizons according to their comfort with market volatility. Conservative clients, for example, usually select longer time horizons and thus a larger allocation to bonds.
Second, the bonds are selected to mature at times when cash is needed (releasing funds, for instance, when the grandkids are ready for college). Because bonds are held to maturity, the price volatility of the securities in the Income Portfolio becomes immaterial. Reinvestment risk is virtually eliminated because coupon interest is consumed by the cash flows.
Third, you don't need to revisit the asset allocation of the entire portfolio. Instead, an increasingly risk-averse client can extend the time horizon of the Income Portfolio at any timeor an advisor can take profits at opportune moments, plow the profits into an extended Income Portfolio and provide a deeper buffer against market volatility.
Choosing a Time Horizon
To demonstrate how easily asset dedication can be explained, consider the following retirement example, shown in "Income Portfolio Cash Flows," page 101. Mr. and Mrs. Smith just retired with $1.8 million of investable assets and plan to withdraw $90,000 per year, increasing at 3% per year for inflation. Assume they want $90,000 in cash for emergencies and to fund the rest of the current year. The allocation to bonds in the Income Portfolio is determined by how long they want their income stream protected. If they choose a five-year horizon, the income stream they wish to protect becomes their "Target Cash Flow," totaling $492,157. Based on U.S. Treasury quotes as of January 2008, a portfolio that would supply the cash flow stream most closely matching the target would cost $447,250, or 25% of their total assets. The balance of their funds, $1,262,750, or 70%, will be invested in stocks. Thus, their allocation becomes 25% bonds, 70% stocks and 5% cash.
If they choose a more conservative, 10-year horizon, the right half of the Income Portfolio chart shows that the required allocation would be 48% bonds, 47% stocks, and 5% cash. In both cases, the correlation between the target income stream and actual cash flows is more than 99%. The match cannot be perfect because bonds must be purchased in $1,000 increments.
For simplicity, the cash flow stream used for the Smiths is smooth, growing at a constant 3% rate. In reality, the mathematics behind asset dedication (called nonlinear programming) can build income portfolios to match any cash flow stream, even an irregular one. The algorithm finds the right bonds in the right quantities with the right maturities to minimize the cost of funding the cash flows.
Dedicated portfolios can also be deferred to start at a future date for clients who are planning to retire or are looking to fund major expenses such as a child's education or wedding. Deferred portfolios can be put in place gradually or all at once and be used before or after retirement. Asset dedication is also ideal for philanthropic vehicles such as foundations or charitable remainder trusts, where the portfolio must support a series of cash flows.