Asset Allocation Mo...
 
Notifications
Clear all

Asset Allocation Modes

14 Posts
6 Users
0 Likes
474 Views
(@hines202)
Reputable Member Customer
Joined: 3 years ago
Posts: 331
Topic starter  

I'm intrigued by the new asset allocation mode. I read the manual on it, and playing with it now. Is there a cliff's notes summary about the difference between the two modes, when to use one vs the other, what brought about the change (what problem it's solving)?

From what I see, if you have a simpler portfolio, i.e just stocks and bonds, want to model just two time periods for asset allocation (pre-retirement and post-retirement), and want more account-level granularity, mode 2 is best.

If you have more asset classes (derivatives, commodities, REITs, etc) and want more time periods, then mode one gives you that.


   
ReplyQuote
(@smatthews51)
Member Admin
Joined: 4 years ago
Posts: 688
 

Bill,

There isn't a Cliff's notes summary, but Mode 2 (overall asset allocation in conjunction with goals for asset location) has been a long-standing request by several users. In contrast to Mode 1, Mode 2 maintains a specified overall asset allocation regardless of differences in rates of return and changes in account balances across the modeling period. You can manually attempt to achieve this via Mode 1 by changing the account-level allocations (actually asset locations) in up to five time periods, but Mode 2 does it automatically. The downside is that Mode 2 can only work with two asset classes (because of the computational complexity involved). I think Mode 2 is particularly useful in conjunction with Roth conversions which have the potential to change account balances dramatically and where you may have substantial differences in the asset classes between tax-deferred and Roth accounts.

Stuart


   
ReplyQuote
(@hines202)
Reputable Member Customer
Joined: 3 years ago
Posts: 331
Topic starter  

Thanks, Stuart. One thing I've encountered pretty often in reviewing clients' Pralana files is that they often start out with the Roth accounts 100% in equities, as they're often small early in the game age-wise and want that aggressive tax-free growth. They don't realize that over time, as conversions happen and that Roth balance swells, they can end up with a very aggressive asset allocation, as well as the problem of needing to then take money from the Roth in a down/devalued market. They haven't adjusted the desired AA in that Roth in later time periods, to make it in line with their desired AA.

This post was modified 2 years ago by Bill Hines, Advice-Only Flat-Fee Investment Advisor, Tax/Financial Planner

   
ReplyQuote
(@golich428)
Trusted Member Customer
Joined: 3 years ago
Posts: 88
 

@hines202 Your observation points one of the gothchas we all need to be aware of and possible trade-offs that we need to make when running the software. I would be interested in how you approach allocations to prevent the creep. The issue of taking money out of the Roth in a down market seems to be more of a practical issue as one gets close to the time of withdrawals from a Roth. I assume would be the last account unless you were doing some tax optimization. In practice they could de-risk the account as they get closer to taking money out but could keep it invested 100% in stocks for many years prior.

In my own plan, I want to have the Roth account 100% invested in stocks and indeed this creates a situation where my overall allocation to stocks in the model can increase significantly if I don't reduce stock allocation in other accounts at different time periods. By reducing stock allocation in other accounts, my overall asset allocation remains within my target in the model. This works and allows for a more realistic comparison of different Roth conversion strategies. The other easier approach I have taken is to just keep the allocation the same for all accounts realizing that this results in some error. This same issue can occur depending on your withdrawal order if you have significantly different allocations in different accounts. This is why I look at the "Allocation" tab often when I am running scenarios.


   
ReplyQuote
(@pizzaman)
Honorable Member Customer
Joined: 3 years ago
Posts: 430
 

Somethings to keep in mind when looking at asset allocation and withdraw strategies: Fidelity has a nice article about withdrawing from all 3 types of accounts (IRA, Roth, Taxable) at the same time based on there relative amounts - https://www.fidelity.com/viewpoints/retirement/tax-savvy-withdrawals

Kitces and others like rising equity glidepath - https://www.kitces.com/blog/should-equity-exposure-decrease-in-retirement-or-is-a-rising-equity-glidepath-actually-better/

https://www.fiphysician.com/modeling-rising-equity-glidepaths-over-a-60-year-retirement/


   
ReplyQuote
(@hines202)
Reputable Member Customer
Joined: 3 years ago
Posts: 331
Topic starter  

@golich428 It's typically not necessary to check/adjust allocation more than once a year (i.e an item in the late-year checklist when checking to see if Roth conversions, loss/gain harvesting, etc should be done). Some folks do it quarterly. Of course, it's harder to measure if you have money spread across different accounts, and certainly in different brokerages. That's where aggregation tools like Personal Capital can be useful, but then you're giving them read-only access to your accounts. Using one brokerage makes this easy, i.e. Vanguard. Most of them allow you to link in your other brokerages as well.

It's good to have a withdrawal strategy from strategic asset locations (call them buckets if you want) as well, to prevent having to tap equities in a down market, unless you want to (i.e. looking for loss harvesting in a taxable account).


   
ReplyQuote
(@golich428)
Trusted Member Customer
Joined: 3 years ago
Posts: 88
 

@hines202 I was not very clear in my question. I was wanting to know how you handle the asset allocations in the different accounts (Regular, Tax Deferred & Roth) through time in the model to prevent the overall asset allocation becoming too aggressive and unrealistic for most retirees. I commented on how I have approached it but was wondering if there are other approaches. Thanks!


   
ReplyQuote
(@hines202)
Reputable Member Customer
Joined: 3 years ago
Posts: 331
Topic starter  

@golich428 Ok, gotcha. It's case-specific really, mostly driven by what I'm seeing in the details of the roadmap presented by Pralana. Of course, it's also driven by the usual logic - if you'll be tapping money in that account within 5 years, it should not be 100% in equities. If something like a Roth won't be used for a long time, go aggressive, sure.

I let Pralana figure out what the most strategic order is to tap accounts (there's the optimization widget for that) and get everything dialed in, then check to see when each account is being tapped and for how much. You can use that to bucketize each account for a specific timeframe, but as I said before, check your AA as part of the bucketing!


   
ReplyQuote
 NC
(@nc-cpl)
Reputable Member Customer
Joined: 3 years ago
Posts: 246
 

I've modeled for decreasing our exposure to equities over the course of retirement, but the Kitces article has me wondering if I've dialed it back too far, particularly light of a longer, high inflation period


   
ReplyQuote
(@golich428)
Trusted Member Customer
Joined: 3 years ago
Posts: 88
 

@hines202 Thanks for the additional information. Roth conversions is also a consideration when selecting withdrawal order. It can get complicated pretty fast.

@nc-cpl The Kitces approach by starting out with a lower equity allocation and increasing it through retirement does help mitigate the sequence of return risk but as he points out, many retirees would have a tough time implementing this strategy and as cognitive decline sets in, I think it would be tough without some help. I think there are better ways to mitigate sequence of return risks - time segmentation (bucketing) and secure income to cover essentials are two that come to mind.

I agree, inflation is a concern but I think it is difficult to model because interest rates will likely increase as inflation increases and I can't think of a good way to handle the linkage. I have stated before my reasons for not using historical returns so that is not an option for me.


   
ReplyQuote
(@hines202)
Reputable Member Customer
Joined: 3 years ago
Posts: 331
Topic starter  

It's easy to feel uncomfortable with interest rates rising and inflation rising, especially for those in or near retirement. But also remember - the Trinity Study (4% rule) modeled periods of both into their analysis, and Monte Carlo and historical simulations in PRC and other tools account for it. Yep, both are rising, and after a bit, both will fall.

Having a solid allocation to fixed income instruments can help avoid having to sell in a down market. Remember how most bucket strategies work - after each year, decide how you will refill the cash bucket that you've just spent one year of money in. If stocks are down, sell a year's worth of bonds, and vice versa. If both are down, ride it out, that's why you have 2-3 years of cash in those methods. It buys you time to ride things out.

In the most recent corrections/recessions, we've shown that through past experiences and newer management techniques they can be mitigated pretty quickly, compared to historical long-running periods of both. Of course, things like WWIII could test that theory...


   
ReplyQuote
 NC
(@nc-cpl)
Reputable Member Customer
Joined: 3 years ago
Posts: 246
 

@golich428 The challenge (assuming we wanted to follow Kitces suggestion) is that we're presently positioned the opposite (heavily into equities at the start of retirement which is now) so we'd have to sell and incur cap gains just to be more in cash and then buy back into equities? The plan has always been the more conventional approach to trim equity exposure during retirement.


   
ReplyQuote
(@soccerdoc)
New Member Customer
Joined: 2 years ago
Posts: 1
 

Can anyone tell me how to actually get to asset allocation mode 2? I don't see it on my copy downloaded just 2 weeks ago. Only has the old asset allocation mode


   
ReplyQuote
(@smatthews51)
Member Admin
Joined: 4 years ago
Posts: 688
 

@soccerdoc Hi Tyler, there's an asset allocation mode selection control at the top of the Financial Assets > Management page.

Stuart


   
ReplyQuote
Share: