Financial advisors should take a page out of the pension industry’s playbook and focus more on a client’s retirement liabilities and less on their portfolio value, according to a research paper by Russell Investments.
Authored by Sam Pittman, Ph.D., and Rod Greenshields, CFA, the paper, titled Adaptive Investing: A responsive approach to managing retirement assets, lays out the framework for using a client’s individual “funded ratio” to determine the proper asset allocation and to guide insurance decisions.
The “adaptive investing” process is said to help advisors manage longevity risk, while providing retirees with a predictable income stream without locking their capital up in an annuity. This allows clients to keep all of their investment options open, while they can always buy an annuity if it is needed.
“Retirees want consistent income from their portfolios and to avoid running out of money before they die,” said Pittman, a senior research analyst at Russell. “They also want to maintain control of their assets for as long as possible. In fact, many would like to be able to bequeath any remaining assets to heirs or charitable organizations.”
The first step of the process will sound familiar to those who have worked in the pension industry. An advisor should start by comparing assets to liabilities—these include future savings on the asset side of the ledger and future spending needs on the liabilities side.
With these totals in hand, the advisor can calculate the ratio of funded to un-funded liabilities. This gives the advisor a starting point for the client discussion on savings, spending, asset allocation and decisions on what types of insurance to employ.
“Advisors play a critical role in helping their clients meet retirement income goals. Russell’s Adaptive Investing approach relies on the investor’s advisor keeping a close eye not only on their client’s portfolio but equally important, on their spending plans,” says Rod Greenshields, co-author of the report and consulting director, U.S. private client consulting group, in Russell’s advisor-sold business.
A primary goal of adaptive investing is to achieve income sustainability for life without initially having to buy an annuity. Rather than purchase an annuity at the outset, the retirement portfolio is managed so that an investor maintains the option to purchase an annuity later.
“Many planning approaches try to mitigate longevity risk by planning to a fixed age that is either at or beyond the life expectancy, but there is still a chance the client may live past the selected ending age,” says Greenshields.
“Using a pre-determined ending age can lead to an overly restrictive spending plan if the age is set too high and an overly risky plan if the age is set too low. Under this framework, investors can preserve flexibility and keep their options open as there is always the option to buy an annuity if it is needed.”
By focusing on the funded ratio, the advisor can shift focus from an asset-only view of portfolio management to a more holistic view that considers both assets and liabilities. In this framework, asset allocation is guided by the client’s wealth, spending needs and lifespan.
To read the entire paper, click here.