Monday, October 13, 2014

Three Portfolios

After my last post on the sensitivity of retirement finance variables to asset allocation, Asset Allocation in Smidges and Dollops, a reader commented that it can be difficult to know what to include in retirement assets and, therefore, how to calculate asset allocation percentages.

And you know what? He's right. It can get complicated.

For a 40/60 portfolio, for example, do I allocate 40% of my total assets to equity or 40% of my liquid assets? Do I include my home equity? A pension or Social Security benefits? How about a fixed income annuity?

An often-asked variation of this question is whether home equity should be included when calculating "sustainable withdrawals".

I suggest the following to make it more clear. Divide all of your assets into three portfolios.

The first, which I'll call the non-retirement portfolio, will contain any investment assets that you choose not to be used to fund your retirement. Your home equity will probably go into this portfolio. If you plan to keep your house and leave it to the kids or to a charity in your will, it goes here.

The non-retirement portfolio will also include money you set aside for your heirs, antique cars, works of art, college savings and any other investment asset that you do not plan to convert to cash to pay for your retirement. Illiquid assets should go here unless and until you convert them to liquid assets. Liquid assets can go here if you don't plan to spend them to fund retirement.

Notice I say that assets go here that you choose not to use to fund retirement. Unless you put the assets in a trust, you can change your mind, move them to another portfolio and spend them later in retirement. This is little more than a "hands-off" sign for assets you hope you won't have to spend for retirement expenses, but that will be there if you need them.

The second portfolio, which I'll refer to as the "floor" portfolio, will contain any asset that will generate retirement income but is not exposed to either market risk or interest rate volatility. This will include Social Security benefits, pensions and fixed income annuities (and probably TIPS bond ladders, though they need further discussion). These sources will provide the same amount of retirement income whether the market sinks or rises and whether interest rates rise or fall. This portfolio will provide a relatively safe floor of retirement income no matter what happens to the stock and bond markets. (I wrote about floors in Unraveling Retirement Strategies: Floor-and-Upside.)

The third portfolio, which I'll refer to as the retirement income portfolio, will contain all assets that you intend to use to fund retirement and that are exposed to market risk and/or interest rate risk. The stream of spending created by the retirement income portfolio (due to the unfortunate acronym, I won't refer to it as the RIP) depends on stock and bond market returns and is risky. Diversifying among multiple stock and bond asset classes helps manage this risk.

I'll make one last point about portfolio contents regarding our homes because it is often a subject of confusion. I initially put the home in the non-retirement portfolio under the assumption that the retiree would keep the house throughout her lifetime. (Surveys show that's what most older American hope to do.)

But, as I mentioned above, these non-retirement assets can usually be accessed for retirement income if you need them.  The equity in a home can be transferred to the retirement income portfolio as cash if you sell the home. Also, the equity can be transferred to the floor portfolio if you take out a reverse mortgage. So, there are ways for your home to provide retirement funds that you can spend, but you have to sell your home or use it as collateral before that can happen.

If you have no plans to downsize or take a reverse mortgage, your home won't be a source of retirement income and should not be used in the sustainable withdrawal rate (SWR) or retirement income asset allocation calculations.

Back to our three portfolios, let's consider their very different natures.

The non-retirement portfolio has no retirement spending rate because you have chosen not to spend from it. The investment horizon may vary for each asset. A grandchild's college costs may need to be covered in three years while investments for heirs may not be spent for decades. Depending on its contents, the non-retirement portfolio may be exposed to market and interest rate risk. Unless the assets are in a trust, you can probably transfer their value to the retirement income or floor portfolios later in retirement. Asset diversification may be beneficial in the non-retirement portfolio, but it isn't linked directly to your retirement income portfolio allocation.

(The non-retirement portfolio isn't completely irrelevant to the retirement income plan. If you have a lot of non-retirement assets, you can take a little more risk with your retirement income strategy, knowing you have these other assets available as a backup in a crisis. If your non-retirement portfolio is empty, you need to be even more careful with your retirement income portfolio asset allocation.)

The floor portfolio, in contrast, provides income that is critical to our standard of living. The assets in this portfolio are not exposed to interest rate risk or market risk. (The exception to this is a bond ladder which I will discuss in a separate post.) Though diversifying among Social Security benefits, pensions and fixed annuities might be beneficial, it is rarely practical. The spending rates for these assets are fixed by the Federal government for Social Security benefits, our pension provider, or the insurance company that sold the fixed income annuity.

Lastly, the retirement income portfolio will have a spending rate, assuming the floor portfolio doesn't cover all of our expenses. It will typically be in the 3% to 4% range of remaining portfolio assets. The assets in this portfolio are exposed to interest rate risk and market risk. The investment horizon is laddered: we will have short term needs, long term needs until the end of our life, and everything in between.

The following chart summarizes the differences between the three portfolios.

So, back to our original questions, which assets are included in the percentages for calculating sustainable spending amounts and asset allocations? The answer is the total assets in the retirement income portfolio. If we move assets from one of the other portfolios (our home equity, for example) into the retirement-income portfolio in the future, we recalculate then.

Which portfolio assets can we move in the future? We can move non-retirement assets or retirement income assets into either of the other two portfolios, though we may have to convert the asset to a liquid form (usually meaning cash) before we do.

Moving out of the floor portfolio is more difficult. We can't move Social Security benefits. Moving a pension or an annuity would mean selling it for what is typically pennies on the dollar and is usually cost-prohibitive. Bonds can be moved to either of the other two portfolios, subject to interest rate risk.

These are important things to know when we are developing a plan. Some parts of the plan can be changed to adapt to changing circumstances over time, like our asset allocation, our spending rate and which assets we hope to bequeath to our heirs and which will we use to pay our own bills.

Other parts of the plan are very difficult to move once executed, typically prohibitive to undo, like changing a Social Security benefits claim or converting a pension or fixed income annuity into cash.

As an example of the asset allocation calculation, if we have $100,000 home equity in the non-retirement portfolio and $200,000 in the retirement income portfolio and would like a 40/60 retirement portfolio allocation, we would invest $80,000 in equities and $120,000 in bonds, ignoring the home equity. How would we allocate the $100,000 of non-retirement portfolio assets? That depends on our goals for those assets, but it may be very different than 40/60.


  1. Dirk, another good post. Again, you have taken a complicated topic and distilled it to it's essence. I like the way you have categorized one's assets into the three buckets. Just an aside, I struggled with Jack Bogle's recommendation to take the present value of one's expected Social Security benefits into account when determining ones retirement income portfolio asset allocation, but in the end like you I chose not to consider it in my asset allocation (though either way made little difference in my case). I do have a question though. I have money set aside for potential long term care expenses. I do plan on using the interest on this money to fund retirement income, but I don't plan on using the principal. I assume this money should be considered as part of my retirement income portfolio and considered in my asset allocation decision correct? Thanks, Brad.

    1. Brad, I am a huge Bogle and Vanguard fan. In fact, I consider myself a closet Boglehead. There are several valid ways to look at this issue, including Jack's. I prefer mine because, as I mentioned, the purpose of asset diversification is to protect against market and interest-rate volatility and Social Security benefits aren't volatile. Non-volatile assets are always a consideration, as I also mentioned. If you have a huge floor, you can take more stock risk, and vice versa, and that is essentially the same thing Bogel is saying. If you treat SS benefits as a risk-free bond and put it in your risky portfolio allocation, then you will buy more stocks for the same asset allocation. But SS benefits aren't exactly like a bond.

      I believe my approach is more in line with Bernstein, who looks at the "shortfall" of retirement income after subtracting Social Security benefits and pensions, and I think it's easier to understand.

      As for which of the three portfolios to put your LTC savings, I believe the retirement income portfolio is the best place. Assuming you will invest them in stocks and/or bonds, and you will spend the income, you're basically hoping that you will have an adequate portfolio to cover both retirement costs and possible LTC costs. The assets are exposed to market and/or interest-rate risk and the income goes to retirement expenses, so that seems like the best place for it.

  2. Re: Home equity.

    I have pondered the question of the house and generally put the home equity into an insurance pool because needing to move out of the house will require moving into another housing arrangement, which can often be quite expensive if it requires assisted living or nursing. As such, it isn't part of the regular retirement income portfolio but is parallel to a long term care insurance policy instead. The asset may get shifted into the income pool at a later date, but isn't relied upon for expenses while healthy.

    1. That's an important point. If you sell your home, you're still going to have to live somewhere. Some of the proceeds from the sale will go to pay the new housing costs no matter where you end up (unless you mooch off the kids, of course). You'll also pay a realtor 6% to sell the house and have moving costs. Whatever's left, you get to turn into income.

      Thanks for writing!

  3. A small point for your consideration: your secure floor concept excludes any reference to inflation-rate risk to go along with the market and interest-rate risks you do identify. If this risk is added to the definition, it alters the relative security of those assets that do provide inflation-rate risk (e.g. Social Security, Inflation-Adjusted Annuities, and TIP bond ladders) to those that don't (e.g. fixed rate pensions and annuities, and nominal bond ladders). Given the potentially large difference between nominal and real income over a multi-decade retirement, I would think the useful concept of a floor would need to factor in inflation risk.

    1. I agree. I recommend inflation-adjusted fixed annuities and I think my preference for TIPS instead of nominal bonds in the floor is well documented. That really only leaves pensions as the floor asset that can't usually be inflation-protected. But the fact that pensions usually aren't inflation protected isn't enough to move them out of the "floor" category. They clearly provide retirement income and they aren't an investment, so they don't fit in the other two.

    2. The concept of a U-shaped spending curve as discussed by Wade Pfau and others means that full inflation adjustment of every "floor" asset may not be critical for the early and middle retirement years. Growth of the retirement income portfolio would be critical to the later years if the rising part of the U spending curve occurs at a significant magnitude. The "non-retirement " part of the portfolio would also act as insurance against this event as well as it can probably be re-allocated in a crisis..

      My spouse's NYS Teachers pension has a relatively complex inflation adjustment component with partial adjustment subject to caps so that it will probably end up with a net adjustment of about one-third of inflation during a typical period. Not great, but better than nothing and reduces the issue in the middle years some.

    3. I believe you are referring to David Blanchett's "spending smile". The paper is available if you Google "Estimating the True Cost of Retirement - Morningstar".

      EBRI has a different estimate of "typical" spending, showing that it constantly declines (Google "Expenditure Patterns of Older Americans, 2001-2009")

      Both of these are arguments for future retirement spending for "typical" retirees, they are different, and neither of them may predict your personal spending pattern.

      My concern with a U-shaped spending pattern is similar to my concern with Pfau's U-shaped asset allocation: if you don't live much longer than the median retiree life span, you won't enjoy much of the right portion of that graph.

      I suggest that you develop a plan to manage inflation, because even low levels will make a big difference if you do live 30 years. And don't count too much on future financial benefits that you might not live to see.

      Does that mean that you can fully compensate for inflation for every floor asset? No, and even if you can you might not be able to afford it.

      Thanks for writing!

  4. Hi,

    This is my first visit as your blog was just recommended by a post on Early- Your division of portfolios resonates with my thinking as I am trying to build a floor with rental real estate. I am expecting overall returns to be equal or better than long term bonds (6%) but less than long term stocks (10%).

    I also figure this gives me inflation protection and allows me to have a higher stock ratio in my "volatile" portfolio than without the real estate... and hopefully leave a bigger estate.

    So long as I maintain generous reserves for maintenance, low or no leverage after retirement, do you see any issues with my allocation of rental income to the floor portfolio.?


    1. I do see issues. I'm not in any way suggesting that you don't have a reasonable strategy for retirement income, but real estate is a risky asset (see 2008) and doesn't belong in the floor portfolio.

      Assets in a floor portfolio should ideally provide income for as long as you live. I grant a small waiver to long TIPs bond ladders of perhaps 30 years, but Social Security benefits and annuities protect against the risk of retirements that might last even longer. A portfolio of rental properties could last that long. On the other hand, I know someone who had $5M of rental properties and lost them all in 2008, which eventually resulted in losing his home.

      Floor assets should also provide safe, predictable income, and by "safe" I mean Treasury bond safe. Real estate rental income isn't that safe and isn't that predictable.

      Floor portfolios are intended to consist of the safest possible assets, capable of providing relatively risk-free, predictable income for as long as you (and a spouse) might live and ideally, with inflation protection. Real estate properties don't fit that description, in my opinion, and belong in your risky portfolio. Social Security benefits, life annuities, and long TIPs Bond ladders do belong there.

      So, I think you might have a reasonable strategy for someone who can tolerate the maintenance issues even after they are quite old (I'm a former landlord, can you tell?), but I don't think real estate is a solid floor, if you'll pardon the pun.

      As for your expected returns, economist Robert Shiller showed in Irrational Exuberance that long-term appreciation of real estate is actually quite low. That won't affect your income, but it might make that estate smaller than you expect.

      Thanks for writing and for visiting my blog. I hope you'll stick around!