Liability Immunization: Bringing Institutional Asset Allocation to Individual Portfolios

Imagine for a moment that you’re a financial advisor and have two 55 year-old clients asking you for advice. They both have $5 million of investment assets, and both of them say they’re willing to take “some” risk. Their question for you: How much of my portfolio should be invested in stocks, and how much should be invested in bonds?

Of all the questions you could be asked, this one seems fairly straightforward, right? There is certainly no shortage of canned answers to this question. Whether it’s taking 100 minus your age to calculate the percentage of your portfolio in equities or taking a “risk tolerance questionnaire” that magically spits out your ideal allocation, the advisory world has made this decision appear simpler than it probably should be.

At Brighton Jones, we have taken a more institutional approach to addressing the question of how much of a client’s portfolio should be invested in bonds, or capital preservation. This approach, called liability immunization, is the same approach used by pension fund managers. We call it our Cash Needs Analysis.

In a nutshell, the Cash Needs Analysis (CNA) computes the next 10-15 years of annual withdrawal needs from a portfolio (if any) and then calculates the present value of those outflows. This present value becomes the lump sum that should be invested in capital preservation. The remainder can be invested in equities and other growth-oriented investments.

By employing this methodology, each portfolio has a customized allocation that directly relates to the cash needs required of the portfolio. For someone who is working and has no immediate need for their portfolio dollars, they may have little or no cash needs and therefore require much less capital preservation. For someone who is retired and withdrawing funds from the portfolio each year, their cash needs will likely indicate a much higher percentage of the portfolio be invested in capital preservation investments.

In either case, the goal is to protect 10-15 years of our clients’ cash needs with cash and bonds to allow the growth-oriented assets ample time to ride out short-term volatility. By using this institutional approach to defining our clients’ capital preservation portfolios, the guesswork and gimmickry of less rigorous methods can be pushed aside in favor of a defensible, rational approach.