STRATEGIC ASSET ALLOCATION: GOALS BASED

Learning Outcome

• recommend and justify an asset allocation based on an investor’s objectives and constraints

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The Lee family case presents a detailed scenario for applying goals-based strategic asset allocation, aligning investment strategies with specific family objectives and constraints. This approach is particularly useful for families like the Lees, who have a complex financial situation involving both substantial assets and significant liabilities, as well as a variety of short-term and long-term goals.

Recommendations for the Lee Family Asset Allocation

Given the Lee family's financial details and goals, here are the recommendations and justifications for their asset allocation:

1. Short-Term Goals (Education and Charitable Gift):

   • Allocation A (40% Cash, 50% Global Bonds, 10% Global Equities): This conservative allocation is suitable for meeting the education goal for David and the charitable gift to the local art museum. The high liquidity and stability of this allocation ensure the funds are readily available when needed, with very high probabilities of meeting these goals.

2. Long-Term Goals (Special Needs Trust and Lifestyle Maintenance):

   • Allocation B (10% Cash, 30% Global Bonds, 45% Global Equities, 15% Diversifying Strategies): This allocation, with a greater emphasis on growth while maintaining some conservative elements, is well-suited for the long-term goals of funding the special needs trust for the granddaughter and supporting the lifestyle aspirations of the Lee family. The higher allocation to equities and diversifying strategies allows for growth potential which is necessary to meet the substantial future liabilities of the trust and lifestyle maintenance, considering the long time horizon.

3. Opportunity in Early-Stage Venture Capital Investment:

   • Given Ivy's unique opportunity to invest in a promising technology, this investment should be considered within the context of their aspirational goals. The investment’s risk and illiquidity make it appropriate for the portion of the portfolio assigned to achieving higher long-term returns, potentially within the "aspirational risk bucket." However, it's crucial to ensure that this investment does not overly concentrate their portfolio in the life sciences sector, given Ivy's existing human capital in this industry. Diversification strategies should be considered to mitigate sector-specific risks.

Insights from Goals-Based Asset Allocation

The goals-based asset allocation offers several key insights for the Lee family:

• Customization to Financial Goals: The allocation is tailored to the specific time horizons and risk tolerances associated with each of the Lee family's financial goals, enhancing the likelihood of achieving them.

• Behavioral Finance Considerations: By separating the portfolio into sub-portfolios linked to specific goals, the approach leverages mental accounting tendencies in a productive way, potentially increasing the family's investment discipline and satisfaction.

• Flexibility and Adaptation: The approach allows for adjustments over time as the family's goals evolve or as they achieve certain milestones, such as the completion of David's education or changes in the value of their assets.

Addressing Risks and Uncertainties

• Longevity Risk: For the lifestyle maintenance goal, considering longevity risk is crucial. Strategies might include setting aside a portion of the assets in an annuity to ensure a steady income stream later in life, beyond the actuarial life expectancy.

• Market Risk and Diversification: Given the long-term nature of some of the Lee family's goals, ensuring proper diversification across asset classes and geographic regions is essential to mitigate market risks.

In conclusion, a goals-based strategic asset allocation approach allows the Lee family to align their investment strategy with their varied and specific financial goals, providing a structured framework for managing their assets and liabilities over time. This approach emphasizes the importance of understanding each goal's time horizon and risk profile, thereby tailoring the investment strategy to increase the likelihood of achieving these goals while managing the family's overall risk exposure.

We use the hypothetical Lee family to present some thematic elements of a goals-based approach.

Investor Case Facts: The Lee Family

• Name: Ivy and Charles Lee

• Narrative: Ivy is a 54-year-old life sciences entrepreneur. Charles is 55 years old and employed as an orthopedic surgeon. They have two unmarried children aged 25 (Deborah) and 18 (David). Deborah has a daughter with physical limitations.

• Financial assets and financial liabilities: Portfolio of SGD 25 million with SGD 1 million in margin debt as well as residential real estate of SGD 3 million with $1 million in mortgage debt.

• Other assets and liabilities:

  • Pre-retirement earnings are expected to total SGD 16 million in present value terms (human capital).

  • David will soon begin studying at a four-year private university; the present value of the expected parental contribution is SGD 250,000.

  • The Lees desire to give a gift to a local art museum in five years. In present value terms, the gift is valued at SGD 750,000.

  • The Lees want to establish a trust for their granddaughter with a present value of SGD 3 million to be funded at the death of Charles.

  • The present value of future consumption expenditures is estimated at SGD 20 million.

Exhibit 11:

Lee Family Economic Balance Sheet (in SGD millions) 31 December 2016

Assets		Liabilities and Economic Net Worth
Financial Assets			Financial Liabilities
Investment portfolio	25		Margin debt	1
Real estate	3		Mortgage	1
Extended Assets			Extended Liabilities
Human capital	16		David’s education	0.25
			Museum gift	0.75
			Special needs trust	3
			PV of future consumption	20
			Economic Net Worth
			Economic net worth (economic assets less economic liabilities)	18
Total	44			44

The financial liabilities shown are legal liabilities. The extended liabilities include funding needs that the Lees want to meet. The balance sheet includes an estimate of the present value of future consumption, which is sometimes called the “consumption liability.” The amount shown reflects expected values over their life expectancy given their ages. If they live longer, consumption needs will exceed the SGD 20 million in the case facts and erode the SGD 18 million in equity. If their life span is shorter, SGD 18 million plus whatever they do not consume of the SGD 20 million in PV of future consumption becomes part of their estate. Note that for the Lees, the value of assets exceeds the value of liabilities, resulting in a positive economic net worth (a positive difference between economic assets and economic liabilities); this is analogous to a positive owners’ equity on a company’s financial balance sheet.

From Exhibit 11, we can identify four goals totaling SGD 24 million in present value terms: a lifestyle goal (assessed as a need for SGD 20 million in present value terms), an education goal (SGD 0.25 million), a charitable goal (SGD 0.75 million), and the special needs trust (SGD 3 million).

The present value of expected future earnings (human capital) at SGD 16 million is less than the lifestyle present value of SGD 20 million, which means that some part of the investment portfolio must fund the Lees’ standard of living. It is important to note that although the Lee family has SGD 18 million of economic net worth, most of this comes from the SGD 16 million extended asset of human capital. Specific investment portfolio assets have not yet been dedicated to specific goals.

Goals-based asset allocation builds on several insights from behavioral finance. The approach’s characteristic use of sub-portfolios is grounded in the behavioral finance insight that investors tend to ignore money’s fungibility26 and assign specific dollars to specific uses—a phenomenon known as mental accounting. Goals-based asset allocation, as described here, systemizes the fruitful use of mental accounts. This approach may help investors embrace more-optimal portfolios (as defined in an asset-only or asset–liability framework) by adding higher risk assets—that, without context, might frighten the investor—to longer-term, aspirational sub-portfolios while adopting a more conservative allocation for sub-portfolios that address lifestyle preservation.

In Exhibit 11, the Lees’ lifestyle goal is split into three components: a component called “lifestyle—minimum” intended to provide protection for the Lees’ lifestyle in a disaster scenario, a component called “lifestyle—baseline” to address needs outside of worst cases, and a component called “lifestyle—aspirational” that reflects a desire for a chance at a markedly higher lifestyle. These sum to the present value of future consumption shown in the preceding Exhibit 11. Exhibit 12 describes these qualitatively; a numerical characterization could be very relevant for some advisers, however. By eliciting information on the Lees’ perception of the goals’ importance, the investment adviser might calibrate the required probabilities of achieving the goals quantitatively. For example, the three lifestyle goals might have 99%, 90%, and 50% assigned probabilities of success, respectively.

Exhibit 12:

Lee Family: Required Probability of Meeting Goals and Goal Time Horizons

Goal	Required Probability of Achieving	Time Horizon
Lifestyle—minimum	Extremely high	Short to distant
Lifestyle—baseline	Very high	Short to distant
Lifestyle—aspirational	Moderate	Distant
Education	Very high	Short
Trust	High	Long
Charitable	Moderate	Short

Because the Lees might delay or forego making a gift to the museum if it would affect the trust goal, the trust goal is more urgent for the Lees. Also note that although parts of the Lees’ lifestyle goals run the full time horizon spectrum from short to distant, they also have significant current earnings and human capital (which transforms into earnings as time passes). This fact puts the investment portfolio’s role in funding the lifestyle goal further into the future.

Goals-based approaches generally set the strategic asset allocation in a bottom-up fashion. The Lees’ lifestyle goal might be addressed with three sub-portfolios, with the longest horizon sub-portfolio being less liquid and accepting more risk than the others. Although for the GPLE pension, no risk distinction was made among different parts of the pension liability vis-à-vis asset allocation, such distinctions are made in goals-based asset allocation.

What about the Lees’ other goals? Separate sub-portfolios could be assigned to the special needs and charitable goals with asset allocations that reflect the associated time horizons and required probabilities of not attaining these goals. A later reading on asset allocation in practice addresses implementation processes in detail.

Types of Goals

As goals-based asset allocation has advanced, various classification systems for goals have been proposed. Two of those classification systems are as follows.

Brunel (2012):

• Personal goals—to meet current lifestyle requirements and unanticipated financial needs

• Dynastic goals—to meet descendants’ needs

• Philanthropic goals

Chhabra (2005):

• Personal risk bucket—to provide protection from a dramatic decrease in lifestyle (i.e., safe-haven investments)

• Market risk bucket—to ensure the current lifestyle can be maintained (allocations for average risk-adjusted market returns)

• Aspirational risk bucket—to increase wealth substantially (greater than average risk is accepted)

EXAMPLE 7

Goals-Based Asset Allocation

The Lees are presented with the following optimized asset allocations:

Asset Allocation	Cash	Global Bonds	Global Equities	Diversifying Strategies
A	40%	50%	10%	0%
B	10%	30%	45%	15%

Assume that a portfolio of 70% global equities and 30% bonds reflects an appropriate balance of expected return and risk for the Lees with respect to a 10-year time horizon for most moderately important goals. Based on the information given:

Because of her industry connections in the life sciences, Ivy Lee is given the opportunity to be an early-stage venture capital investor in what she assesses is a very promising technology.

1. What goal(s) may be addressed by Allocation A?

   Solution to 1:

   Allocation A stresses liquidity and stability. It may be appropriate to meet short-term lifestyle and education goals.

2. What goal(s) may be addressed by Allocation B?

   Solution to 2:

   Allocation B has a greater growth emphasis, although it is somewhat conservative in relation to a 70/30 equity/bond baseline. It may be appropriate for funding the trust because of the goal’s long time horizon and the Lees’ desire for a high probability of achieving it.

3. What insights does goals-based asset allocation offer on this opportunity?

   Solution to 3:

   Early-stage venture capital investments are both risky and illiquid; therefore, they belong in the longer-term and more risk-tolerant sub-portfolios. Ivy’s decision about how much money she can commit should relate to how much excess capital remains after addressing goals that have a higher priority associated with them. Note that economic balance sheet thinking would stress that the life sciences opportunity is not particularly diversifying to her human capital.

Discount Rates and Longevity Risk

Although calculation of assets needed for sub-portfolios is outside the scope of this reading, certain themes can be indicated. Consider a retiree with a life expectancy of 20 years. The retiree has two goals:

• To maintain his current lifestyle upon retirement. This goal has a high required probability of achievement that is evaluated at 95%.

• To gift $1 million to a university in five years. This is viewed as a “desire” rather than a “need” and has a required probability evaluated at 75%.

Suppose that the investor’s adviser specifies sub-portfolios as follows:

• for the first decade of lifestyle spending, a 3% expected return;

• for the second decade of lifestyle spending, a 4.6% expected return; and

• for the planned gift to the university, a 5.4% expected return.

Based on an estimate of annual consumption needs and the amount of the gift and given expected returns for the assigned sub-portfolios, the assets to be assigned to each sub-portfolio could be calculated by discounting amounts back to the present using their expected returns. However, this approach does not reflect the asset owner’s required probability of achieving a goal. The higher the probability requirement for a future cash need, the greater the amount of assets needed in relation to it. Because of the inverse relation between present value and the discount rate, to reflect a 95% required probability, for example, the discount rates could be set at a lower level so that more assets are assigned to the sub-portfolio, increasing the probability of achieving the goal to the required level of 95% level.

Another consideration in determining the amount needed for future consumption is longevity risk. Life expectancies are median (50th percentile) outcomes. The retiree may outlive his life expectancy. To address longevity risk, the calculation of the present value of liabilities might use a longer life expectancy, such as a 35-year life expectancy instead of his actuarial 20-year expectation. Another approach is to transfer the risk to an insurer by purchasing an annuity that begins in 20 years and makes payments to the retiree for as long as he lives. Longevity risk and this kind of deferred annuity (sometimes called a “longevity annuity”) are discussed in another curriculum reading on risk management.27

There are some drawbacks to the goals-based approach to asset allocation. One is that the sub-portfolios add complexity. Another is that goals may be ambiguous or may change over time. Goals-based approaches to asset allocation raise the question of how sub-portfolios coordinate to constitute an efficient whole. The subject will be taken up in a later reading, but the general finding is that the amount of sub-optimality is small.28