|JAMES H. WILSON, CPA/PFS, is director of personal financial
planning for Blackburn, Childers & Steagall PLC and BCS
Financial LLC, both in Johnson City, Tennessee. In 1988, he was
the first recipient of the AICPA PFP division's outstanding
service award. His e-mail address is JIM@BCScpa.com. |
WILLIAM G. DROMS, CFA, DBA, is Powers Professor of Finance at Georgetown University in Washington, D.C. His e-mail address is Droms@gunet.georgetown.edu.
Retirement planning is not as easy as it used to be. Nearly everyone seeks financial independence, but for many reasons, financial and otherwise, this goal is becoming harder to achieve. Asset allocation is a strategic element of investing for a financially secure retirement, and individual investors, with the help of their CPAs, must understand how to allocate assets earmarked for retirement, both in and out of retirement plans.
Asset allocation is the process investors go through of distributing portfolio investments among available asset categories, money market instruments, bonds, stocks, real estate and other assets. Selecting the right asset mix for a diversified portfolio is the single most important determinant of long-term investment performance.
In a widely quoted study, Determinants of Portfolio Performance, in the July-August 1986 issue of the Financial Analysts Journal , Gary Brinson, L. Randolph Hood and Gilbert L. Beebower devised a test to gauge the contributions of three investment management activities, investment policy (asset allocation), market timing and security selection, to performance. They found that investment policy dominated market timing and security selection.
In their analysis of 91 large U.S. pension plans, 94% of plan performance was the result of asset allocation. In short, the impact of capital allocation among asset classes totally overrides what securities an investor owns within each asset class. In a diversified portfolio, for example, deciding which specific stocks to hold will have much less impact on total performance than deciding the percentage of the total portfolio allocated to equity investments relative to other asset classes.
FUNDING A COMFORTABLE RETIREMENT
For participants in defined contribution retirement plans such as 401(k) or 403(b), selecting an appropriate asset allocation mix is key to financing a comfortable retirement. The principles discussed in this article apply to all types of retirement plans, including qualified plans, IRAs or even deferred compensation.
Employees traditionally have been on their own when it came to selecting plan investments because some employers were reluctant to provide explicit advice on retirement options. However, in 1996 the Department of Labor issued the DOL Interpretive Bulletin on Participant Education , which made it easier for employers to offer assistance to retirement plan participants. The DOL bulletin tells employers how they can provide investment information to plan participants and beneficiaries without incurring fiduciary responsibility under ERISA for providing investment advice.
The DOL guidelines give employers four safe-harbor activities that fall outside the scope of investment advice. An employer can provide
- Plan information. This includes materials that inform a participant of the benefits of plan participation, investment alternatives under the plan and the benefits of maximizing contributions.
- General financial and investment information. This includes information on general investment concepts such as risk and return analysis, the benefits of diversification and historical rates of return.
- Asset allocation models. These include pie charts, graphs and other depictions of asset allocation models, provided the models are (1) based on generally accepted investment theories, (2) accompanied by all underlying material facts and assumptions, (3) accompanied by a statement of the availability of similar investment alternatives under the plan and where participants can obtain them and (4) accompanied by a statement advising participants to consider their other assets, income and investments as well as investments in other plans.
- Interactive investment materials. They include questionnaires, worksheets, software and other materials that give a participant a means to estimate future retirement income needs and future potential income.
The DOL bulletin says an employer's selection of someone to provide investment education or advice to plan participants is an exercise of discretionary authority or control, and the person making that selection must act in accordance with the ERISA fiduciary standards.
Based on the guidance in the DOL bulletin, CPAs have an excellent opportunity to help employers that want to educate qualified plan participants about their investment options. Many employers find they have trouble convincing employees to participate in the company 401(k) retirement plan. This problem gives CPAs a chance to develop and present education programs for corporate clients and could be an excellent source of new business with new or existing clients. Such programs can include information on investment options, including some of the asset allocation techniques discussed here, and the long-range benefits of participating in the plan. (For practical advice on how to develop such a presentation, see How to Sell' the 401(k) to Employees, JofA, Oct.98.)
The importance of asset allocation goes beyond the traditional view of diversification as a way to avoid putting all your nest eggs in one basket. For CPAs, managing client expectations, making sure the returns clients expect are realistic, also is an important part of the asset allocation process. Strategic planning to determine the appropriate asset mix requires investors to consider three dimensions of investment planning: risk, return and diversification. Risk reduction is a key element. Typical CPA firm clients are both risk-averse and loss-averse. Risk-averse clients require a high expected return in exchange for taking more risk. Loss-averse clients also want to minimize the probability of losing money. An important objective of retirement investment planning, therefore, is to achieve the highest possible return at whatever risk level the client is willing to accept and to diversify broadly across asset classes to minimize the probability of losing money.
In helping a client allocate his or her retirement assets, the CPA's primary task is to know the client. Doing so typically involves several steps, the first of which is to ascertain the client's goals and objectives. There are many ways CPAs can get clients to start thinking about their goals. For a form we have used successfully to spur discussion with clients about their future, see exhibit 1.
Next, the CPA needs to consider what stage of life the client is in. A younger person will likely be willing to assume more risk than someone closer to retirement. However, assessing the client's true risk tolerance can be difficult; clients often have a lower risk tolerance than they are willing to admit.
To measure risk tolerance, we use a questionnaire known as the portfolio allocation scoring system (PASS) one of us developed (see JofA, Apr.87, page 114). An updated version is shown in exhibit 2. Exhibit 3 is a modified version of the scoring system developed for CPAs to help clients begin the asset allocation process for retirement plan contributions.
A client's retirement income needs are an important part of the process, as are his or her available resources. These assets may or may not generate sufficient discretionary income to support the client's proposed investment program. CPAs will find the form reproduced in exhibit 4 useful in calculating the annual savings a client needs to reach a particular retirement income level.
After determining a client's goals and objectives, stage of life, risk tolerance, income needs and available resources, the CPA then can gauge how much risk the client must accept to meet his or her retirement objectives. We call this the speed of money. It is directly related to the client's goals and objectives as well as his or her available resources and the risks to be assumed to reach those goals and objectives.
This concept is perhaps best explained by analogy. If CPA John Roe, with offices in Johnson City, Tennessee, a two-hour drive from Knoxville, allows the necessary two hours to reach an appointment in that city, he can observe the speed limit and avoid the risks of speeding. If, however, he does not allow enough time to reach his destination at the appointed hour, then he has to accept the risks inherent in speeding, including the risk of being involved in an accident. If he does not exceed the speed limit, he will be late for his appointment. The same can be said of investing to reach a goal. If an investor has sufficient resources or discretionary income to reach his or her goals while assuming a minimum amount of risk, then it would be foolhardy to accept more risk to achieve an objective that can be gauged by a conservative approach. However, if the investor's resources are not sufficient or if time is short, it may be necessary for the investor to lower his or her objectives or assume more risk to achieve the established financial goals.
To devise an appropriate asset allocation strategy for a client, a CPA must consider the possible impact of inflation and adjust the allocation accordingly. In times of stable inflation, investment advisers tend to recommend a strategic allocation that is evenly divided among the basic investment groups of cash, stocks and bonds. In times of high inflation, the tendency is to adjust the strategic asset allocation so it is more heavily weighted toward assets that respond favorably in those circumstances, such as real estate and precious metals.
FIVE STEPS TO A SECURE RETIREMENT
CPAs can better help clients invest their retirement assets by following a five-step asset allocation process to arrive at a specific portfolio.
1 Determine the client's investment objectives by using some of the techniques outlined above. After getting to know more about the client from the data-gathering form in exhibit 1 and the PASS questionnaire, a CPA can make a rough portfolio allocation. While it is not meant as a fail-safe means of solving all of an investor's planning needs, the PASS score does provide the CPA with a useful way to turn investment objectives and personal risk tolerance into an action strategy.
2 Select a strategy for structuring the client's retirement portfolio. The CPA will be faced with two choices: active management, which is based on the idea a manager can add to a portfolio's risk-adjusted return, and passive management, which is based on a strong belief in the efficient-market hypothesis. That hypothesis says the market is so efficient a manager cannot add significant value to a portfolio by successfully anticipating future events. Index funds offer investors a simple and inexpensive way of gaining access to passive management.
3 Decide how funds will be allocated among different styles of investing. Exhibit 5 shows the track record of four different equity investment styles, value, growth, yield and index, from 1982 to 1993. Our analysis of the success of these styles shows that over the 12-year period, each is successful approximately 25% of the time. A conservative approach would be to spread equity investments evenly among the four styles. (This style cycle applies only to equities and not to fixed-income investments.) Six style factors characterize fixed-income investments, short term, intermediate term and long term and high, medium and low quality.
4 Select the asset classes in which the retirement portfolio will be invested. CPAs can help clients divide asset classes between equities and fixed income as follows:
- Equities can be divided by market capitalization, or cap, into large-, mid- and small-cap stocks and then further into international, global, real estate (usually real estate investment trusts) and precious metals.
- Fixed income can be divided into investments such as corporate bonds, municipal bonds (not usually appropriate for tax-qualified plans), U.S. Treasury obligations, certificates of deposit, guaranteed income contracts and money market funds.
5 Develop a specific portfolio. In selecting the specific securities that make up the retirement portfolio, the CPA's goal is to meet the client's investment objectives with a minimum of risk. Inflation, the client's age and resources and risk tolerance are also important in deciding which investments will best help the client reach his or her goals and objectives.
DO IT WITH NO-LOAD MUTUAL FUNDS
One cost-effective way to allocate retirement assets is to use no-load mutual funds. Many clients already have this option available to them through their company-sponsored 401(k) plans. No-load funds offer investors three major advantages that are difficult to achieve with individual securities.
Mutual funds in general are broadly diversified, giving
investors the opportunity to spread the risk of investing by buying
shares in portfolios that include many different stocks or bonds.
The brokerage commissions paid by mutual fund companies are very
small compared with the rates individuals pay.
- Mutual funds provide professional management at relatively low
cost. The total expense ratios, including management fees, generally
run about 1% to 1.2% of the dollar value of a fund's assets.
- No-load funds do not charge a commission on the amount invested. For investors and CPAs willing to do their own research, no-load mutuals are an extremely low-cost way to construct a diversified investment portfolio.
After the client has implemented the asset allocation recommendations, with no-load funds or with individual securities, the CPA's next job is to monitor the portfolio's performance. Using mutual funds to build a retirement portfolio makes it easy for a CPA to keep an eye on the client's investments. Performance statistics for periods ranging from one month to 3, 5 or 10 years are easily available. Ongoing monitoring will make necessary changes easier to spot. CPAs should not, however, be too quick to judge a fund's performance in a short period of time. It should have four to six quarters of poor performance before you pull the plug.
A STRAIN ON THE SYSTEM
As the United States stands on the threshold of the 21st century, the classic population paradigm of an equilateral triangle, with a smaller, older population at the top and the younger population on the bottom, has given way to a rectangle, with as many older people at the top as there are young people at the bottom. This shift in population is placing many strains on the retirement system. Companies are feeling the pinch of offering employees lucrative retirement benefits, and how far into the next century the Social Security system will survive is still an open question. So it has become increasingly important for individuals, with the advice of their CPAs, to provide their own retirement funds to ensure financial independence. Asset allocation is one important aspect of how an individual can begin to prepare for his or her financial independence day.