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  • #31




    I think both Rex and Kon make insightful points.  I think the type of allocation, agressive or conservative, depends on the client.

    For the scenario of a client who has multiple employees, is close to retirement, or has already amassed a large 401k plan, a conservative allocation is probably best.  As far as I’m aware, this has historically defined the client seeking out a DB/cash balance plan.  With multiple employees, a conservative allocation will reduce employer liability.  If the client is close to retirement then the volatility of an agressive allocation may cause issues with cash flow and changing contribution amounts.  If the client already has a large 401k plan (this client probably already has the other two qualities) then a large % of bonds in the DB may still represent a small % in his total portfolio.

    However, I think Rex represents a different client which is similar to me.  Late 30s-40s, at least 20 years from retirement, no employees, smaller 401k plan, uses broad based diversified index funds.  I agree that a DB/cash balance plan is not about contributing the most over time to maximize tax deferrals but rather paying the least to get the same defined benefit.  So if a client is 15-20 years away from retirement, no employees, okay with volatility in his portfolio, and capable of handling changing contribution requirements due to volatility with regard to cash flow then I think an agressive portfolio is fine.   If a client has 15-20 years to fund the plan, then I don’t think volatility will significantly affect contribution requirements (however I need to confirm this an actuary).  One just needs to make sure plan does not become overfunded if investments do well.

    I was told by a TPA to aim for an annual investment return of similar to the plan, 5.5%, however I struggle with the opportunity cost of not being agressive.

    Interestingly, as long as it does not affect cash flow, I think the volatility with an agressive allocation is actually good in the long term with a DB plan.  If stocks are down, the plan becomes underfunded and contribution requirements are raised.  If stocks are up, the plan becomes overfunded and contribution requirements are lowered.  Basically, it forces buy low, sell(or not buying) high

    I will likely plan to follow a target date retirement glidepath with maybe 10% more bonds for my DB/cash balance plan.

    Thoughts?

     

     
    Click to expand...


    In a solo plan you can definitely use any approach that fits your goals.  I would start with an overall allocation and figure out where the DB plan fits in.  As I said before, 10 years is not a long horizon at all so it is inconsequential what the DB allocation is as long as your overall allocation is where you want it to be.  Higher return is always more preferable to a tax deduction. Volatility is simply not good for a large portfolio in the grand scheme of things because of the timing issues, so a higher return (in theory) can become a lower return due to volatility (in practice) because of bad timing (which we have no control over).  Therefore, my position is that lower volatility is always preferable, regardless of where the money is (401k or DB), and higher return is not guaranteed by having a higher volatility portfolio.  That said, I prefer a barbell-type approach where I take significantly more risks on one side of the portfolio than S&P500, and significantly lower risks on the other side.  This is an 'all weather' type allocation that's also known as barbell (and in practice this results in a lower volatility).  Though historically these allocations generated returns on par with S&P with significantly lower volatility, we don't know if this would be the case going forward, but this 'target risk' approach in my opinion is a better approach than target date one.  So basically, my approach is to dial down on the risk by using Treasuries, and take all of the risk on the stock side.  Thus it does not matter where the investment occurs, as long as the overall allocation fits a specific goal, then individual components can be managed accordingly.

    Those using target date approach will have a significantly more difficult time managing their allocation, and timing issues come into play a lot more with this approach, that's why I prefer the target risk one any time of day, regardless of what returns are.  I'm more worried about losses than not getting a higher return (which we have no control over anyhow), so I'd rather get a smaller error on a lower return assumption with a barbell-type allocation than a huge error on a higher return assumption with a high volatility portfolio.  For those accumulating millions risk is a lot more damaging than not getting extra return (which is far from guaranteed in any case).
    Kon Litovsky, Principal, Litovsky Asset Management | [email protected] | 401k and Cash Balance plans for solo and group practices, fixed/flat fee, no AUM fees

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    • #32
      Past performance does not dictate future returns.  But the graphs in this link highlight the value of holding stock longterm.

      http://allfinancialmatters.com/2012/08/29/sp-rolling-total-returns-1-5-10-20-25-and-30-years/

       

      the S&P 500 has never suffered a loss in a 20-year period.  Only a few 10 year periods have had a negative return.

       

       

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      • #33




        You have no idea if you error will be small by using a conservative approach/lower return assumptions.  Very easily your bonds approach will also greatly underperform.  Ten years is just a number you made up for length of plan.  These plans are supposed to be indefinite.  You have no idea what will actually be more damaging.  Good luck matching the S&P with the bond approach.
        Click to expand...


        I never said I'm using all bonds.  On the contrary, if you re-read what I posted above, I'm very much in favor of holding stocks.  My approach/allocation is different from what is typically done, that's all. Nobody knows whether this will do better or worse than any other approach, and when I keep talking about lower return, that's not guaranteed either - it could be a higher return.  Over the past 40 years the return of this type of allocation matched that of S&P with no bonds, but I'm just being extremely careful not to try to make predictions from past returns.  The whole point is managing risk, and if this can be done with less volatility, then that's what I'm shooting for.
        Kon Litovsky, Principal, Litovsky Asset Management | [email protected] | 401k and Cash Balance plans for solo and group practices, fixed/flat fee, no AUM fees

        Comment


        • #34




          Past performance does not dictate future returns.  But the graphs in this link highlight the value of holding stock longterm.

          http://allfinancialmatters.com/2012/08/29/sp-rolling-total-returns-1-5-10-20-25-and-30-years/

           

          the S&P 500 has never suffered a loss in a 20-year period.  Only a few 10 year periods have had a negative return.

           

           
          Click to expand...


          Please see the chart above I posted titled 'The Stock Returns Never Average' above.  It matters very little what rolling returns are (and these are nothing but averages over longer and longer time periods).  Why?  The markets are fat-tailed, and fat-tailed statistics has different properties from Gaussian statistics.  One of the properties is that past averages have no bearing on the future (in a Gaussian world past averages are stable and future returns will converge to them eventually). So just because S&P only had a 50% loss doesn't mean it can't go down 60%.  And just because the longest recession was 10 years doesn't mean it can't be 15. And 'never suffered a loss' is not particularly useful if you are losing 50% of your portfolio (and this would have a huge impact on your total and annualized return).  Timing matters when investing in risky assets, so when you just accumulated say $5M and the market goes down 50% this will significantly impact the total return/annualized return, and even though over 20 years you might suffer no loss (by the way it could be 25 years, and 30 years as longer/deeper recessions come about, which is only a matter of time), the net result would be catastrophic for those holding 100% stock portfolios hoping they'll recover (and getting hit by another longer recession with a deeper bottom). Fat tailed markets simply have more degrees of freedom than Gaussian ones, and so things that Gaussian statistics says is impossible is very much possible (and not only that, but also bound to happen eventually).  So to me the only thing that matters is limiting the downside, and getting whatever return that one can get with a barbell allocation.  Historically this has worked well (except during the times when interest rates were low, due to artificial government involvement).

          Vanguard's own retirement distribution calculator shows that a 50:50 allocation is more stable over longer periods of time (30-40 years) than 100% stock allocation (when no more contributions are made).  Also as you get older, subsequent contributions have less and less impact on the overall portfolio, so Vanguard's analysis applies much earlier than distribution.  Bottom line is that once we take into account real risk that the market statistics shows us, in order to manage long term risk to a large portfolio, the traditional age-based asset allocation is significantly flawed, and most people's understanding of how long term risk works is also flawed, which can be easily demonstrated with basic mathematics (even Gaussian math works for that). Risk increases with time, and no amount of averaging will be able to hide it, so in light of that, I believe that only a risk-based approach is the most prudent long term strategy vs. target date or age-based approach.

           
          Kon Litovsky, Principal, Litovsky Asset Management | [email protected] | 401k and Cash Balance plans for solo and group practices, fixed/flat fee, no AUM fees

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