Cash Flow Planning

Cash Flow Planning

Risk tolerance over time

I attended a conference earlier this week and one of the featured speakers, Jeffery Coyle of Monograph Wealth Advisors in California, discussed the role of fixed income over time in an asset allocation strategy. The presentation was thought-provoking because it was, in many ways, contrary to generally accepted industry practices.

Conventional asset allocation strategies often suggest that a person’s risk tolerance may change over time and become less aggressive, particularly as they shift from accumulation to decumulation in retirement. By then, the time to build the nest egg has passed and the key driver becomes income generation and/or capital preservation. Within the industry, we have seen the emergence of target date fund strategies which implement this philosophy. The closer an individual gets to retirement, the more conservative their portfolio becomes as the equity weightings are reduced in favour of lower-volatility fixed income.

Have we got it wrong?

In reality, as we are living longer, many retirees have decades of post-employment years and they require their capital to sustain them. By shifting too much to fixed income or assets with low expected returns, we can sometimes see an increased risk of premature capital depletion. In addition, many individuals have a strong desire to create a legacy or leave an inheritance for their families. This means that, not only do we need to ensure adequate capital growth for the individual, but often we need to account for future generations as well.

The success of an individual’s wealth planning is directly linked to cash flow. If we accurately estimate one’s cash flow, it is much easier to calculate the required rate of return and the appropriate level of risk assets to include in a portfolio. Often, we use current expenditure as the starting point to help ensure one can maintain their present standard of living throughout retirement. However, Coyle suggests that if we consider the minimum required expenditure instead of the current outflows (i.e. stripping out discretionary spending), we can solve how much fixed income is required to cover this baseline need. Over time, this need decreases as one’s life expectancy reduces. This means, using this philosophy, an individual would actually shift toward a heavier equity weighting as they move into retirement. This unique approach could be incredibly powerful for high net worth individuals or families who are looking to maximize their estate or legacy over time.

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