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How Advisors Can Help Find The Optimal Asset Allocation For Clients

by Doug Carey | Dec 03, 2012

One of the best ways for advisors to help clients with their retirement portfolios is to change their asset allocation strategy. Sometimes this means reallocating their investment mix to a more aggressive approach and sometimes this means reallocating to a more conservative mix.

There are at least three problems with convincing clients to change their allocation: 1) Many people simply fear change and they need serious convincing in order to do so. 2) Many advisors try to talk their clients into changing their strategy rather than showing how these changes would likely impact their retirement situation in the future. 3) Some advisors might not understand how to find the optimal allocation strategy themselves and are therefore not confident enough to attempt to convince their clients.

I believe that finding the right asset allocation strategy for each client is one of the best ways advisors can add value for clients. That is why we have come with a way to make this task much easier for advisors through our Asset Allocation Scenarios feature.

Using Asset Allocation Scenarios advisors can now run multiple asset allocation scenarios at one time and view how each one changes the probability (using Monte Carlo analysis) of clients achieving all of their retirement goals. Advisors can create multiple allocation mixes and view how each one impacts the plan. Typically an advisor will create a range of allocation strategies, ranging from very conservative to very aggressive. For example, a very conservative mix would be mostly in cash and bonds while the very aggressive mix would be heavily weighted in emerging stocks and even user-defined asset classes such as frontier stocks or commodities.

Let’s take a look at an example of how we can analyze a client’s retirement situation based on changing their asset allocation strategy.

I ran an analysis in our WealthTrace Retirement Planner  to see what kind of impact changes in a client’s asset allocation strategy might have. I used a plan for a couple that is 45 years old and plans on retiring at age 65. Here were my starting assumptions:

Inflation (CPI)

3.00%

Current Age of Both People

45

Age Of Retirement

65

Age When Both People Have Passed Away

95

Social Security at age 67 (combined)

$40,000 per year

Average Savings Rate

10% on Income of $100,000

Total Investment Balance Today

$600,000

Recurring Annual Expenses in Retirement

$65,000

Investment Mix

60% U.S. Value Stocks, 5% Emerging
Market Stocks, 35% Treasuries

Investment Location

50% in taxable accounts, 50% in IRAs

Average Return Assumption Value Stocks

7% per year

Standard Deviation Value Stocks

16.20%

Average Return Assumption Emerging Mkt Stocks

9% per year

Standard Deviation Emerging Mkt Stocks

25.80%

Average Return Assumption Treasuries

1.5% per year

Standard Deviation Treasuries

7.20%

After generating their plan and running Monte Carlo analysis I found that the probability of this couple achieving all of the retirement goals is 55%.

For most people this is not an acceptable number. Part of the advisor’s job is to help clients boost their odds of never running out of money. There are several obvious ways to help clients do this. They can save more money, retire later, or spend less in retirement. Of course, many clients don’t want to do any of these. That’s why changing the asset allocation mix can be such an easier sell. Let’s take a look at the asset allocation strategies I chose to run scenarios with:

Treasury Bonds
(Medium-Term)

Value Stocks

Emerging
Market Stocks

Conservative

70%

30%

0%

Somewhat Conservative

60%

40%

0%

Middle Of The Road

40%

50%

10%

Slightly Aggressive

25%

60%

15%

Aggressive

15%

65%

20%

Very Aggressive

10%

40%

50%

The percent figures in the middle of the grid represent the percent allocated to each asset class in each strategy. For example, the Aggressive strategy is one in which the clients’ asset are moved to 15% in Treasuries, 65% in Value Stocks, and 20% in Emerging Market Stocks. I only chose three asset classes in this example to keep it fairly simple. Of course, there are many other asset classes that can be chosen from when creating these strategies.

Let’s look at the results from the scenarios I ran:

Allocation Strategy
Before Retirement

Allocation Strategy
During Retirement

Probability Of
Funding All Goals

Today's Strategy

Today's Strategy

55%

Conservative

Conservative

25%

Somewhat Conservative

Somewhat Conservative

36%

Middle Of The Road

Somewhat Conservative

55%

Slightly Aggressive

Somewhat Conservative

65%

Aggressive

Somewhat Conservative

75%

Very Aggressive

Somewhat Conservative

71%

Note that I have them moving to the “Somewhat Conservative” strategy when they retire in most of the scenarios. This is more realistic given that most people don’t want to be too aggressive with their investments once they retire.

The results from the Asset Allocation Scenarios are enlightening. Notice how the conservative strategies are most definitely a losing proposition. It’s not too surprising given that this couple is relatively young. The strategy that is the most effective is the Aggressive strategy. This gives them a 75% chance of achieving all of their retirement goals compared to 55% with their current allocation. In other words, they are clearly not being aggressive enough today with their investment mix.

Perhaps the most interesting thing I found from this analysis is the fact that it’s a good idea for this couple to be more aggressive, but not too aggressive. The probability of success eventually declines as risk goes up. The” Very Aggressive” strategy has a lower probability of success than the Aggressive strategy. This shows that many variables in a retirement plan are nonlinear and how so many things interact, such as the client’s current age, the retirement age, social security payments, etc. Monte Carlo analysis captures these complexities and it’s one of the reasons it is so valuable. It would otherwise be impossible to tell which of these strategies is “too risky” for this couple.

Showing clients how to increase their chances of a successful retirement through changing their asset allocation can be a win-win. The clients obviously win because they are increasing the chances of never running out of money and they don’t necessarily have to retire later or spend less in order to do it. The advisor wins because he or she can add tremendous value for clients and convince them that this is a strong reason the advisor should be managing their assets.




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