Monday, September 12, 2011

Asset Dedication

Today’s classic retirement planning study is the 2004 book, Asset Dedication: How to Grow Wealthy with the Next Generation of Asset Allocation, by Stephen J. Huxley and J. Brent Burns.

This book is very interesting and speaks to some very important issues for retirement planning and so it is hard to know where to begin in discussing it.
First of all, this book suggests an approach to retirement planning that is similar to Raymond J. Lucia’s Buckets of Money. I’ve read that book as well, but from my perspective of wanting to simulate things to see how they work for myself, I find Asset Dedication to provide a clearer framework.  The many possible permutations and variations of Buckets of Money leave me a bit overwhelmed to know where to start testing it.

For those who are already familiar with Buckets of Money, a few differences in Asset Dedication include:

-The Asset Dedication authors do not like annuities [their opposition is based on fees built into annuities among other things... this is an area where I need to do more reading before I can have any opinion: financial professionals tend to either love or detest annuities and I don’t know who is right]

-Asset Dedication involves actually locking in future spending needs with specific bonds, whereas Buckets of Money allows for various bond mutual funds and other possibilities that do not specifically lock-in a spending goal

-Asset Dedication limits asset classes to stocks, bonds, and bills, which certainly is quite simplifying in comparison to the exotic possibilities of Buckets.

When I read Buckets of Money and Asset Dedication, the main issue that concerned me is that in some scenarios (though it doesn’t have to be this way, as I will explain), the stock allocation for retirees can creep up to 100% before  shorter-term buckets are refilled / new assets are dedicated to short-term expenses.

Huxley and Burns are quite upfront about this issue, as they believe strongly in the “stocks for the long-run” idea that stocks provide superior performance for sufficiently long periods of time.

That makes me nervous.  One thing is quite clear from the U.S. historical data though, which is that stocks have performed best.  I’ve seen this time and again in my research.  100% stocks support higher maximum sustainable withdrawal rates, largest wealth accumulations at retirement, lowest safe savings rates, and so on.  But before fully embracing the Asset Dedication approach, I do want to consider Monte Carlo simulations that allow for more scenarios to compare Asset Dedication to traditional asset allocation, in order to see how they perform in worst-case scenarios.   The superior performance of Asset Dedication shouldn’t just happen because it has a higher stock allocation, but because there really is something meaningful going on with its differing approach to the asset allocation question.  

I don’t have my answers about the Monte Carlo simulations yet, but I hope to look at it sometime.  It is not perfectly straightforward, because I cannot just simulate total returns for stocks and bonds.  I also need to simulate bond yields and the bond yield curve, because the whole purpose of buying bonds with Asset Dedication is to precisely lock-in future spending needs.

With all that background out of the way, let me now discuss how Asset Dedication works in relation to traditional asset allocation.

The authors are critical of traditional asset allocation, because other than saying that risk tolerant individuals can hold more stocks, there is no clear way to decide on the appropriate allocation between stocks, bonds, and bills.  In asset allocation, bonds are treated as “stocks-lite”, in which a volatile bond mutual fund is held that still fluctuates in value, but just to a lesser degree than stocks. This approach is tied up too much in a sort of single period framework which abstracts away from an investor’s goals, which in this context is to build a nest egg that will allow for desired spending amounts in retirement up to age 100. 

Short-term volatility shouldn’t matter except when it is time to start withdrawing funds from the portfolio.  As such, Asset Dedication doesn’t call for using bonds to reduce portfolio fluctuations.  Rather, bonds should just be used to lock-in future spending amounts as retirement approaches.  Or, if one’s portfolio grows ahead of schedule and meets the wealth target goal early, bonds can also be used to lock-in the goal since further portfolio growth is not needed.

That’s the idea of Asset Dedication.  Don’t treat bonds as stocks-lite.  Use stocks to achieve portfolio growth and use bonds to lock-in spending amounts.  What this typically means is that people should have a 100% stock allocation until they either reach their wealth goal or get close enough to retirement to lock-in some spending.  Just a note, the authors encourage the use of an indexed mutual fund for stocks to save on fees and avoid active management. Only the minimal amount needed to lock-in spending should go to specific bonds, and the rest should be in the stock index fund.

To the extent that this provides an improvement over traditional asset allocation, it helps to devote as much as possible to growth assets, and it helps to avoid having to sell stocks after momentary drops, because nothing will need to be sold until it is time to lock-in more spending.  Essentially, someone with greater risk aversion can lock-in a longer spending stream, which devotes more to bonds, and then allow the remaining stocks a longer time to compound before needing to be sold.

About the time horizon to lock-in spending, the book offers several possibilities.  In each case, the authors discuss a 5 year span as a reasonable choice, but the span could be anywhere from 3 years to 10+ years depending on the risk aversion of the investor.  Longer horizons will lock-in a longer period of spending and will increase the bond allocation, with the (potential) downside of reducing the stock allocation and decreasing the growth potential of the portfolio. The possibilities are:

1. Fixed horizon: Dedicate assets to cover the next 5 years. At the end of 5 years, start over and dedicate assets for the following 5 years after that.  This approach doesn’t sound appealing to me, because this is the way you end up with 100% stocks at the end of each of these fixed horizons before you make the updates.

2. Rolling horizon: I like this one better. Start with a 5 year horizon, but at the end of each year sell enough stocks to buy a new 5-year bond to lock-in spending for another year.  This keeps the planning horizon always at 5 years.

3. Flexible horizons: This just allows for more flexible to change the horizon depending on how stocks are performing or the level of interest rates, though be careful about getting involved with market timing when doing this. One good idea here is to lock in a longer period whenever stocks have performed particularly well.  This would also help if you believe that market valuations affect subsequent stock returns, as it could help you avoid becoming too greedy as your portfolio grows beyond your goals. 

One final comment: I really like the discussion in the book about “critical paths” to determine if the portfolio is on target. Comparing where it is now with where it needs to be to achieve one’s goals.  I recently had a blog post in which I was doing something similar, and I think it is a great way to think about these problems.  I think it would be interesting to investigate the interactions between how wealth targets are conceived in this book along with how I look at retirement goals in terms of the savings rate used rather than the wealth accumulation amount, in my “safe savings rates” paper.

I like this book a lot, and I do want to make some simulations based on it to be more confident about the approach.  The authors do a great job making a convincing case for Asset Dedication instead of Asset Allocation, and I just want to see for myself that it is not too heavily reliant on “stocks for the long run” because all of its tests were based on historical data since 1926.  So stay tuned...

Disclosure: This blog post sounds like a commercial for the book.  I’ve had the opportunity to exchange some friendly emails with author Stephen Huxley after he wrote to me about my “safe savings rates” article, and that is how I learned that this book exists.  But I do not have any sort of financial relationship or anything like that with the Asset Dedication company. After reading the book, I do just happen to find it genuinely interesting.


  1. I haven't read the book so I am just responding to your blog comments on it, but I would not think being 100% in stocks would be the optimal configuration for the lead up to tapping the funds to lock in spending. If one could pick their end date, this might work, but this would have been disastrous in 2008. Given one never know what will happen, I would think the optimal asset allocation would reflect more of the 50/50-75/25 stock/bond mix that shows more forgiveness in downturns with modest sacrifice on return (even though we are talking about the "growth"/accumulation part of the equation). But maybe his approach has a twist in how/when the bonds lock things in that I am missing.

    The retirment income planning idea that has resonated the most with me was the Income Harvesting approach outlined by Zachary S. Parker in a August 2008 Journal of Financial Planning article. He basically says keep a rolling 3-7 year bucket for income by continually filling it when you have excess returns and riding on this bucket when the market is negative. I am curious of what you think of his approach. The idea of harvesting excess returns is often the missing discipline needed to take advantage of positive markets (make hay when the sunshines as they say.....).

  2. Thanks a lot for the comment. I haven't read that article yet, but it has definitely moved to the top of my reading list. What you are writing makes perfect sense to me. I may not have explained it well, but I think this approach could also fit into the "3. Flexible horizons" category I mentioned above.

    My thinking about this is that more risk averse retirees will want to have a longer average time horizon for fixing in their spending. For someone retiring around 2008, for instance, the risk averse person may have already locked in 10 years of spending and so their stock allocation would have been lower already. Also, I think that this horizon should be flexible for the exact reasons you state. I'm definitely going to read that article now. Thanks again!

  3. For anyone interested, here is a link to Zachary Parker's article:

    1. Thanks Wade: however the link didnt work for me. In case others also have trouble I found one at

      however it is not a very good quality copy of the article

  4. I'm glad to read your post since I am not yet familiar with this book, which seems to adopt the basic principle I am coming to believe should underpin investing during retirement - namely, that one should be matching liabilities / spending with assets / investments with respect to timing, price volatility, inflation characteristics e.g. owning a house perfectly matches housing expenditure liability.

    The big question with regard to stocks, and an assumption that you state clearly enough, is whether the future will be like the past. Or will it be different next time? Being blindly confident that stock market history will repeat itself seems to me inadequate. The assumption needs to be directly addressed. To that end I suggest that the book Economic Transformations by Lipsey, Carlaw and Bekar provides tests (and from my reading, reason to hope) of conditions needed for economic growth, and therefore stock market growth, to continue. Of course, as has been noted also, economic growth does not ensure stock market success. Profits can be captured by others than public stockholders.

  5. I read the Asset Dedication book when it was first published in 2004. Overall, I think it provides a much better approach to retirement investment planning than the probability-based approach because it promotes asset-libability matching. As you point out, however, asset dedication procedures need to be vetted because it relies on the equity portion of the portfolio to refurbish the bond ladder over time. Thanks for your review of this critical retirement planning topic, and I look forward to your conclusions after Monte Carlo testing the various asset dedication approaches outlined in the book.