One of the most discussed and yet least understood aspects of investment is asset allocation. It is a fairly simple concept and poses the question of how to best achieve the investor’s goal. This requires the investor to articulate the goal, an agreed definition of ‘best’, and a full understanding of the factors that might help achieve, or cause deviation from, the goal. The discussion usually takes place in investment committees but I think it might be instructive to take it down to an individual level or ‘retail’ as the industry would have it. Let us consider a retired person with a pot of capital which needs to last (often two people) an unspecified period. How should this person (couple) approach asset allocation?
The individual does not know how long she will live or what care she might need. She will have a state pension and the right to certain state benefits in certain circumstances. She will be subject to higher rate taxes if she takes too much income in any one year. She might wish to leave a legacy or help non-dependent but cherished relatives. Even for an individual it is a complex problem. One must first present the problem in a tractable form. This will typically involve simplifications and assumptions. If the problem is not well-defined it cannot solved.
Quite often, and typically in my generation, the main asset will be an owner occupied house. Is this to be considered an asset? One could impute a rental value and add the rental value to income. If part of the goal is to live in this property until death one still needs to consider any IHT arising, and the impact on state assistance with care costs. One solution might be to extract equity from the property whilst retaining the right to live there until death. This is feasible but comes at a cost. The released equity could be used to generate additional income. It also reduces the estate value and residual value for care cost purposes.
Once the pot of investable assets is established then the investment decision needs to be addressed. The simplest decision is to buy an inflation-linked annuity. The provides complete certainty however long she lives. There is protection against inflation and as an insurance product FSCS protection (in the UK). So if an equity release scheme is used the right to reside in the ‘home’ is secured until death and the annuity plus state and other pensions define income. The annuity evaporates on death and the equity release almost certainly leaves nothing also. There is no legacy and no IHT and the annuity can defer care costs until death. For a single person not concerned about leaving a legacy and seeking absolute certainty of income (and not worried about paying higher rate tax), this is a reasonable asset allocation strategy. It can be adapted to a couple.
Now assume she wishes to leave a legacy and certainty of income is not so urgent. The estate may be large enough that income could incur higher rate tax and this might be deemed inappropriate. A large estate may also allow more risk to be taken. The income target is set at whatever keeps tax within the basic rate band. No equity release is necessary so the home remains an asset that will be available for inheritance. The investment strategy now becomes maximizing real return subject to keeping income at the maximum consistent with the basic rate tax band. The investment problem is now quite different.
One is now looking for assets that offer real asset value growth and not real income growth. Income incurs tax whilst asset growth only incurs CGT if realised and it can always be realised if need be. CGT is usually levied at a lower rate and there is a CGT allowance. If one is concerned about inflation one will seek assets that perform well in inflationary environments. One will be looking for ‘growth’ assets and not income assets, at least for part of the portfolio. This is not the usual recommendation for retired people but it follows from the objectives of this retired person. If the strategy is successful there may also be a need to transfer assets early to minimise IHT though if a large part of the portfolio is in drawdown this may not be necessary.
The point of the exercise is to illustrate that asset allocation begins with a clear understanding of a problem to be solved. It is not a one size fits all issue yet one size fits all solutions are common. In the UK the corporate pension plans regulator requires a funding calculation based (in effect) on how much it would cost to transfer the liability stream to an insurance company. This is equivalent to buying an annuity. This is why ‘deficits’ are so large. In practice there is an asset allocation strategy that would match the liability stream for considerably less. The solution is very similar to the one for the retired lady seeking a specific income and to leave a legacy.
The liability stream for a pension plan depends upon longevity, employment growth, wage growth, and inflation. All but longevity is a macro factor. Longevity has surprised on the upside in recent decades but it is not a linear extrapolation process. The macro factors can be related to specific asset classes and thus it is possible to construct portfolios that hedge these macro factors. In general any investment problem can be reduced to sensitivity to a set of macro factors and can be solved by a portfolio of assets which have the appropriate macro factor sensitivity. At any time the asset value can deviate from the central sensitivity but this is an opportunity rather than a problem. Sensitivities may also change and this may require portfolio restructuring. It is a continuous and dynamic process of monitoring and adjustment to ensure the portfolio matches the objective. This is asset allocation. Factor models ( such as Quant Insight ) provide the tools for constructing and adjusting such portfolios. But first, one must define the problem…