ASSET DEDICATION STEP BY STEP Investing with Ms. Smith
STEP 5: DEDICATE THE INCOME PORTION OF THE PORTFOLIO
The secret to asset dedication is precision-guided bonds: buying the right bonds in the right amounts with the right maturities at min- imum cost to match the target withdrawal stream. Both interest payments and principal redemptions must be factored in simul- taneously. Bonds purchased for Year 5 will generate interest and principal to pay for Year 5 itself, but will also generate interest for Years 1 through 4. Therefore, fewer bonds will be needed to fund Years 1 through 4 because of the interest payments from the Year 5 bond. The Year 4 bond will have the same effect on Years 1 through 3, and so on. This is where the mathematics can get tricky. Ms.
Smith needs to invest just enough in bonds maturing in each year for each year’s income need to be satisfied by the maturing bond principal plus the interest on the bonds remaining in the portfolio.
The asset dedication web site (www.assetdedication.com) uses com- puterized techniques to find the minimum-cost bonds to accomplish the trick.
By following the asset dedication strategy, Ms. Smith or her adviser almost completely eliminates the four major risks of bonds:
1. Default risk. This is gone because Ms. Smith chose U.S.
Treasury bonds. If she had purchased lower-quality bonds,
such as corporates or munis, some slight risk of default would remain. How much depends on the quality of the bonds purchased, their maturity date, and so on.
2. Reinvestment risk. This is gone because the interest and principal are not reinvested. They are used for income.
3. Inflation risk. This is almost gone because we factored in 4 percent inflation over the entire planning horizon. If inflation on the items that Ms. Smith buys averages 5 percent, then Ms. Smith will have lost 1 percent in terms of purchasing power, so we cannot claim that this risk is entirely gone. She could have selected a higher inflation rate, of course.
4. Market risk. This is gone because all bonds are held to maturity. There is no need to worry about their interven- ing values in the market. They will not be sold before they mature.
To demonstrate the actual flow of funds for Ms. Smith, we will assume that all bonds pay exactly the same coupon rate of inter- est, namely 6 percent, and all are selling at par. That is, they pay exactly $6 per year per $100 invested, and their current price is exactly $1000, making their yield 6 percent also. Ms. Smith will collect the interest from all bonds each year and will hold each bond until it matures.
By dedicating just enough of her assets to bonds, she will sup- ply her income needs over the next 5 years—no more, no less. The first year’s funding would take $30,000 cash, and the bonds for the following 5 years would cost $141,720, a combined total of $171,720 (see Table 3.2 and Figure 3.2). Recall that her overall need was for
$198,989 including inflation. The principal repayments will cover 86 percent of this, and interest will cover the other 14 percent.
Note that the allocation to bonds is no longer based on some arbitrary percentage, as it is in the XYZ asset allocation formulas. It has a rational foundation. It is dedicated to guaranteeing an income stream over the next 5 years. Ms. Smith’s investment strategy is not based on her like or dislike of her financial adviser, on faith in some faceless research department somewhere, or on an arbitrary formula.
Note also that the XYZ formulas become meaningless with asset dedication. The percentage allocations to stocks, bonds, and cash now depend on the length of Ms. Smith’s planning horizon, the income she wants, and the size of her portfolio. For example, her initial allocation to cash is enough to fund her initial withdrawal of
Asset Dedication—How It Works 45
Table 3.2
Dedicated Portfolio Cash Flows from Interest and Principal
Target
Year Income Interest Principal
0 $30,000 $30,000
1 $31,200 $8,503 $22,697 2 $32,448 $7,141 $25,307 3 $33,746 $5,623 $28,123 4 $35,096 $3,936 $31,160 5 $36,500 $2,066 $34,434 Total $198,989 $27,269 $171,720
As % 100% 13.70% 86.30%
Figure 3.2
Dedicated Portfolio Cash Flows from Interest and Principal
$8503 $7141 $5623 $3936 $2066
$40,000
$30,000
$20,000
$10,000
$0
$22,697 $25,307 $28,123 $31,160 $34,434
$31,200 $32,448 $33,746 $35,096 $36,500
1 2 3 4 5
Year Interest
Principal
$30,000 for her first-year support, which we assumed to be a full year. If her portfolio had a total of $600,000, then this $30,000 allo- cation to cash would represent 5 percent; her $141,720 allocation to bonds would be 23.6 percent; and the remaining $428,280 allocated to stocks, 71.4 percent. So in asset allocation terms, she would ini- tially have X = 71.4 percent in stocks, Y = 23.6 percent in bonds, and Z = 5 percent in cash (see the left pie chart in Figure 3.3).
If, however, she had a $1,000,000 portfolio and withdrew the same income stream starting at $30,000, her allocations would be X = 82.8 percent in stocks, Y = 14.2 percent in bonds, and Z = 3 per- cent in cash. Notice that under asset dedication, her goals become the driving force in her asset allocation, not a formula based on arbitrary percentages. And these dedications are customized to her individual needs, not to the imagined needs of a generic class of investors.
This example assumes bond yields of 6 percent for all the bonds in the portfolio regardless of their maturity, i.e., a flat yield curve. In the real world, 1-year bonds usually have lower interest rates than 5-year bonds. The yield curve that charts yield against maturity date is usually positively sloped. So the actual cost of the income portion of a portfolio and corresponding allocations will differ from case to case. Indeed, the cost will change minute by minute, as the prices of bonds fluctuate just like the prices of stocks.
Furthermore, the percentage allocated to any single asset class changes over time. As the years pass, and Ms. Smith progresses along the time line of the planning horizon, bonds mature and the proceeds are used for income. This means that the percentage of
Asset Dedication—How It Works 47
Figure 3.3
Initial Asset Allocation Percentages Depend on the Size of Ms. Smith’s Portfolio
$600,000 Portfolio $1,000,000 Portfolio
Stocks 71%
Cash 5%
Bonds 24%
Stocks 83%
Cash 3%
Bonds 14%
the portfolio invested in bonds becomes less and less as she approaches the end of her fixed planning horizon (under a rolling or flexible horizon, it might not). Asset allocation becomes dynamic under asset dedication because it is driven by goals rather than by fixed formulas.12
To understand fully how this all fits together, the interested (and mathematically comfortable) reader is referred to Chapter 7.
There are other complexities involved, but the main purpose here is to demonstrate the basic concept of asset dedication.