Many of your clients may believe that their retirement income portfolio should be invested in securities that explicitly provide regular payments, such as bonds, dividend paying stocks, covered calls, etc. But focusing on dividends emphasizes the income characteristics of these assets over their investment characteristics. For example, "chasing yield" can lead investors to buy questionable investments merely because they offer-at least temporarily-enticing income streams. To effectively manage retirement income, it's important to consider the actual liabilities, including timing, duration, risk, and correlation to other assets, so that the income strategy is truly optimized to meet them.

Russell suggests another approach. Rather than adopting an asset-only view of retirement portfolio allocation, we use an asset-liability model, where the spending needs of the retiree serve as the liability. We do this because the asset allocation should be set according to the relative size of assets and liabilities, their relative risk, and their correlation. Further, as the investor's situation changes through time the asset allocation needs to respond. Doing so reduces risk and increases expected ending wealth. Retirement income adaptive asset allocation is based on these ideas.

Adaptive asset allocation is a multi-period portfolio optimization approach that overcomes many of the shortcomings of mean variance optimization. Advisors should look beyond investment strategies based on mean variance optimization because it solves a different problem than what most retirees have. The real risk retirees are trying to manage is running out of money, not volatility which is central to mean variance optimization. In fact, it's possible that a higher volatility portfolio could actually reduce the chance of an investor running out of money in some situations.

Other features of a retiree's income problem may also make adaptive asset allocation more attractive:
    It directly models retirement cash flow needs and mortality risk, which are more relevant to the problems retirees face.
    It is a multi-period model instead of a single period model. Consequently, risks like return sequence are represented.
    It models risk as shortfall rather than volatility.
    The allocation responds to changes in the client's situation automatically as markets affect her funded ratio.

While the exact decision logic underlying retirement income adaptive asset allocation is quite complex, we focus here on simple intuition.

Intuition would suggest that investors with low funded ratios (i.e., fewer assets relative to their liabilities) have less capacity for market risk than investors with high funded ratios. While this is a logical observation, it's also a result validated by multi-period asset liability portfolio optimization. Exhibit 1 shows a simplified example of how the asset allocation responds to the funded ratio of the investor.

Exhibit 1: Funded ratio and asset allocation

When an investor's plan is adequately funded, she can increase her exposure to equity risk as her funded ratio improves. However, it is also an optimal modeling result for an investor who is currently underfunded (i.e., less than 100%) to increase his market risk as the funded ratio decreases. This is represented by the blue dotted line in the chart.

Although this is an optimal modeling result, we believe that instead of following this policy (the blue dotted line), an investor who becomes meaningfully underfunded should revise his spending plan rather than hoping strong market returns will fix his low funded ratio problem. Lowering planned spending will immediately reduce the liabilities of the plan and improve the funded ratio. Because we don't believe an investor should proceed with a materially underfunded plan, we suggest he remain conservatively invested when the funded ratio falls below a critical level (e.g., 100%). This mitigates the chance of his funded ratio worsening while you work with him to adjust his spending plan.

As we would expect, we can obtain better results when we model the problems a retiree faces, such as multiple periods, specific retirement income needs, shortfall concerns, unknown inflation, and an uncertain time horizon. How much of an improvement to expect depends on the investor's actual plan.

Adaptive asset allocation is designed to improve the efficiency of retirement income outcomes relative to traditional strategies. For examples of the efficiency improvement, refer to (Fan and Gardner 2011) or (Fan et al In prep).  Additionally, we have a retirement income planning tool which compares adaptive asset allocation against other approaches for specific cases. The next section discusses some of the concepts embedded in this planning tool.

Stress Testing The Retirement Plan With Simulation
Retirees each have different spending needs and goals.  You will want to stress test your client's spending and investment plan to better understand the sustainability of the plan. We discuss several metrics here for accomplishing this testing that we compute using Monte Carlo simulation. (Note: For this statistical process, we use 5,000 randomly generated scenarios per year in order to evaluate a broad range of hypothetical economic scenarios over time. These simulations are designed to reflect the forecasted volatility of investment markets and other economic variables, such as interest rates. The Monte Carlo simulated data, or scenarios, are created using Russell Investments' proprietary forecasting models incorporating historical data from market and economic indexes. The scenarios model investment performance for a set of asset classes, the level of interest rates, and the rate of inflation to estimate how each might affect a portfolio balance over time.)

Just as it's important to base asset allocation decisions on both assets and liabilities, both assets and liabilities need to be forecasted during simulation. Retirees need to know that there is a high probability that their funded ratio in the future will also be greater than 100%. Projecting only the value of wealth and not the value of the retirement spending plan (the liability) obscures important aspects of the plan. For example, if inflation increases or interest rates decline, the liabilities of the plan will increase.

While there are many metrics one could consider to diagnose a plan, the following four measures are useful in assessing the viability of a client's plan:
    Current funded ratio - Indicates whether the assets exceed the value of liabilities today.
    Probability of success - Gives the probability that the assets will be greater than or equal to the liabilities at a future date. We use a 10-year horizon for this projection.
    Magnitude of failure - Shows the average size of the shortfall, ten years out, in the scenarios that are not successful.
    Expected surplus - Shows the average amount of wealth in excess of the value of the spending liability ten years in the future.

Consider a hypothetical example to illustrate the metrics above. Jay and Mary Mars are each 72 years old; they have $700,000 in investable assets; and, they want their nest egg to produce $35,000 a year, increasing 2% per year for cost of living. Discounting this liability using a 3% interest rate and adjusting it for mortality gives a net present value of $645,730.

Obtaining the values in Exhibit 2 requires simulation of the plan. We assume they proceed with the withdrawals noted above and invest their assets in a 40% equity / 60% fixed income portfolio which is rebalanced annually. (For this example, we use a static portfolio instead of an adaptive asset allocation strategy. We can, however, compute these same metrics for an adaptive portfolio.)


IMPORTANT: The projections or other information generated by the Monte Carlo simulation engine regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results and are not guarantees of future results. Indexes and/or benchmarks are unmanaged and cannot be invested in directly.

The broad asset class assumptions for equity and fixed income in this portfolio are:           

Annual Expected        Correlation


Returns*    Volatility    Equity    Fixed Income

Equity                    7.2%        16.5%            1     
Fixed Income          4.5%         2.7%      0.204                    1
*Assuming continuous compounding

Fixed income investors should carefully consider risks such as interest rate, credit, repurchase and reverse repurchase transaction risks. Greater risk, such as increased volatility, limited liquidity, prepayment, non-payment and increased default risk, is inherent in portfolios that invest in high yield ("junk") bonds or mortgage backed securities, especially mortgage backed securities with exposure to sub-prime mortgages. Equity investors should carefully consider risks such as market risk when investing. There are no guarantees when it comes to individual stocks. Any stock may go bankrupt, in which case your investment may be worth nothing. Although equities have historically outperformed fixed income, they also have historically been more volatile. Investors should carefully consider their ability to invest during volatile periods in the market

Now, consider the differences between these plan metrics and other commonly used ones.

We define probability of success as investing for ten years while also having enough wealth to continue the spending plan at the end of 10 years. If an investor maintains enough wealth to continue lifetime spending after 10 years, then they are effectively managing longevity risk. This is not the case where probability of success is defined as having a positive wealth at a fixed terminal age.

We also consider an additional aspect of risk-magnitude. In addition to knowing how often the plan fails, indicated by the probability of success, it's also useful to know by how much a plan fails when it fails. The magnitude of failure measures the average size of failure.

Consider two potential scenarios for a client who starts with a funded ratio of 120%. In one scenario, her funded ratio declines to 98% in ten years. In the other, it falls to 50%. By our definition, each outcome is a failure because the funded ratio is less than 100% at the end of 10 years. But clearly the second case, in which the client has only half the wealth she needs, is much worse. This is important to consider when evaluating a plan. Once again, we observe the importance of forecasting liabilities in addition to wealth. To measure how far an investor might fall short of their goals, we need to forecast the value of both the assets and the liabilities.

In addition to assessing risk, projecting both assets and liabilities into the future provides advisors with more insight about potential estate values. Expected surplus measures the amount of assets above what is needed for funding retirement spending. You can think of this as the expected amount of wealth potentially available for future bequests or increased spending, with the understanding that it could also provide a cushion in case markets perform unfavorably.

Monitoring investment outcomes as they unfold
Even with a sound and well tested plan, it's critical to monitor progress at frequent intervals. Unexpected events that compromise retirement success are easier to deal with when they are caught early. Many advisors review plans annually to make sure their clients are on track. But it also makes sense to monitor the funded ratio at a more frequent interval. Keeping a close eye on the funded ratio is a simple and effective way to catch a plan heading in the wrong direction. If you detect a plan with a low funded ratio, you'll want to take action as soon as possible.

We've already discussed how the adaptive asset allocation approach shifts the allocation to respond to a changed funded ratio. Unfortunately, there may be cases where more drastic measures are needed. Some potential ways to course-correct outcomes caused by unfavorable investment results or too much spending are to:
    Revise the spending plan to increase the funded ratio
    Exercise the option to purchase an immediate life annuity, securing a portion or all of the necessary distributions.
Investors typically don't like either of these options because they involve reducing spending or losing flexibility. Fortunately, a responsive asset allocation paired with careful monitoring can help mitigate such drastic actions.

The value of Adaptive Investing relies on the advisor's management of their clients' funded ratios. Regular monitoring is required to successfully manage the option to defer annuitization.  Markets can shift quickly causing a client's funded ratio to drop. While the asset allocation will respond as a first line of defense, you will want to develop a regular monitoring procedure and review contingency plans with clients.

Adaptive Investing requires collaboration between investment managers and advisors, working jointly towards the goal of improving retirement outcomes for individual investors. For investors to receive the full benefit of Adaptive Investing, they will need advisors who evaluate their funded status, choose reasonable spending plans, characterize investment risks, and then discuss options they may need to select in the future. With each participant specializing in their area of expertise-the investment manager providing best thinking on asset allocation and longevity risk management and the advisor guiding client decision-making-investors will be in a better position to achieve the retirement lifestyle they desire.

Advisors and investors can use adaptive investing as a tool to evaluate an individual's risk of running out of money in or before retirement. Adaptive Investing is Russell's suggested approach to retirement income -- by looking at the value of an individual portfolio at any point in time, and comparing that to a cost of a lifetime pension stream that an investor can actually buy, advisors can help retirees ensure consistent income from their portfolios.

Rod Greenshields is a consulting director for Russell Investments' U.S. advisor-sold business. Rod is responsible for the delivery of tailored consultative expertise in the areas of investment management, practice management, and capital markets insight to Russell's most important distribution relationships. In this role, he provides advice on portfolio strategy creation and capital markets research to advisors and financial services organizations who share Russell's commitment to a long-term investment discipline on their clients' behalf.

Sam Pittman works in Russell Investments' asset allocation group, focusing on investment solutions to meet retirement income needs. Sam is engaged in the design of multi-period asset liability models and planning approaches to maximize retirement sustainability. Sam supports investment solutions for private client practitioners and defined contribution plans.