Product allocation is more important than ever

Advisors looking to demonstrate the value of advice to clients can now point to retirement income planning. Groundbreaking work, done by Canadian personal finance expert Moshe Milevsky, is changing the way portfolio creators are conceptualizing boomer retirement and creating a lucrative new income stream for competent advisors.

Milevsky, professor of finance at York University, in addition to being executive director of the IFID Centre and president and CEO of the QWeMA Group, recently held a webinar – sponsored by Manulife Financial – on the need to allocate a retiring client’s wealth across products rather than asset classes.

Most clients, and a high number of advisors, still think of an asset class as the key determinant of a retirement portfolio’s risk protection. The very crude rule of thumb for the last three decades has been that a client, age 60 or older, should have a portfolio with a fixed-income allocation of 40% or more.

The concept: Dividends and interest from the fixed income pay for expenses in retirement and the equities portion creates income sustainability by growing and slowly converting into income. Advisors get that and so do their clients.

But Milevsky points out last year’s events show a portfolio without sufficient guarantees to protect against a negative sequence of returns – especially during the earlier stages of retirement – can drastically reduce the longevity of a retiree’s income. He’s even developed a new risk measure, the Sequence of Returns Downside Exposure (SORDEX) ratio, which measures how vulnerable a plan is to abnormal market conditions.

An advisor could create a traditional investment portfolio for a retiree with ostensibly strong income sustainability under an expectation of normal market fluctuations, but Milevsky says a Black Swan event – arguably what happened in late 2008 – could decimate one of these portfolios. So, it’s become more important than ever to create a portfolio with the wealth clearly distributed across three product classes:

• traditional annuities, such as single premium income annuities (SPIA);
• variable annuities with a lifetime benefit, such as a GMWB; and
• traditional securities-based portfolios (systematic withdrawal portfolio).

“People should allocate their wealth in retirement across three different silos – mutual funds, stocks and bonds on one side; pure pensions and income annuities on the other – because they generate sustainability that’s not subject to income conditions,”he says. “The third allocation is any type of investment that provides downside protection, sequence-of-returns protection, upside participation and upside ability.”

The best example would be a guaranteed life withdrawal benefit. When markets perform very well, sequence of returns work like a mutual fund.

You can get a sense of the SORDEX ratio by running comparative simulations on a portfolio. Milevsky says when advisors run their client portfolios through an analytical tool such as a Monte Carlo simulation, they need to run two tests, one for the current set of assumptions on the actual client and another for a hypothetical client with the same portfolio, but using extreme market events.

“Divide one [simulation] by the other and you get a sense of the sensitivity of client portfolios to an extreme event. You’ll find you can have two clients in different situations but equivalent sustainability numbers. However, when you run it for extreme situations the numbers are very different,”Milevsky notes. “Under extreme market conditions you get to see what might happen when things go extremely wrong. When you include different products in the mix, the sustainability numbers get much better.”

Advice is crucial

Milevsky’s quantitative modelling – using different products – is being viewed by many practitioners as nothing short of revolutionary. Advisors made a lot of money in the last two decades introducing the idea of asset allocation, which could be monetized by selling a diversified portfolio of selected mutual funds.

The concept behind diversified portfolio construction is extremely well known and is of diminishing value to advisors. Many clients are opting to do it themselves or want diversification created with low-compensation products such as ETFs.

When it comes to retirement income product allocation, Mike Henkel, managing director, retirement services group for the Chicago-based Envestnet Asset Management, says you need a pro.

Henkel is former president of Ibbotson and Associates, where he first met Milevsky. He now uses the Canadian academic’s work to create efficiently allocated portfolios for advisors.

Henkel says when he started work at Ibbotson in the early 1990s, advisors were just starting to get out of the whole “let’s sell some securities”mindset and were transitioning to a more fee-based practice focused on diversification. Looking back, Henkel reminisces those advisors didn’t really understand diversification principles, mean variance optimization, correlation or standard deviation. “Now, they all understand asset allocation.”

Boomers who were then entering their 40s and saw a need to grow wealth quickly drove the mutual fund craze of 1990s. Henkel expects them to drive a similar craze for efficient income planning, where product allocation will be the best strategy for a proper retirement portfolio.

“As baby boomers retire, particularly without pensions, we’ve got to make our own wealth last as long as we can. I think this type of income planning will be, if not as completely popular as investment diversification, as close to it as it can be,”he says.

That’s good news for advisors, because distribution and planning on the guaranteed products is something only advisors, in conjunction with portfolio experts, have the ability to execute.

Implementing allocation

Advisors are crucial to product allocation, considering there’s no cookie-cutter solution. Henkel points out, when using Milevsky’s algorithms in Monte Carlo simulations, there are probably 700 different baseline portfolio allocation solutions as opposed to the standard seven in asset allocation. From there the advisor has to do more work in allocating based on a number of risk factors.

“You cannot get the optimal allocation of these products in 10 seconds,”Milevsky says. “Product allocation is more complicated as you have to look at age, gender, whether the client has a pension, and risk tolerance.”

Milevsky advocates tactical – active – allocation of products. “Advisors need to monitor and rebalance the product allocation to maximize the portfolio’s efficiency,”he says.

He also advocates creating a strategic baseline allocation based on the various factors and client goals, adding advisors should alter the allocation to take advantage of market conditions. For example, many advisors are hesitant to buy an SPIA right now because one school of thought believes interest rates are going to increase over the long term, considering they’re at historical lows right now.

Product allocation works nicely because different product classes are correlated to different market conditions. The systematic withdrawal portfolio will, for example, help offset diminished gains of an SPIA in a climate of rising interest rates. The variable annuity can supplement this process by offering some upside potential from its underlying investment portfolio.

“Investors should be strategically allocating their product allocations. But tactically there may be market conditions where you overweight or underweight those products, given the unique circumstances in those particular markets,”Milevsky says. “For example if a company comes out with a really attractive product that might be available in limited supply, and was not previously available, I would deviate the allocation of that product.”

Milevsky adds he would deviate from a hypothetical strategic 1/3,1/3,1/3 allocation. For example, if the yields on SPIA and pension products decline, even if he’s a really big fan of that product class, he might reduce the overall allocation to those products. As someone actively building these portfolios, Henkel says allocations are a challenge. Right now he doesn’t see a lot of value increasing his allocations to variable annuities, for example, which in the U.S. have increased in price and offer fewer features.

“All the work we’re doing right now is almost exclusively with income annuities. We just don’t see many advisors who use our portfolios selling variable annuities at this point,”Henkel says. “Even if your client is targeting anywhere between a 4% and 4.5% withdrawal rate, on current pricing you’ll see an SPIA allocation north of 50% in the portfolio.

“And as your withdrawal rate goes higher, your annuity allocation goes lower. As interest rates rise – and ultimately they will – the annuity payouts will go higher and the allocation will get adjusted to reflect that new regime of interest rates.”