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Retirement Allocations to Floor and Surplus Portfolios

| | Posted in: Strategic Allocation

How can retirees optimally segregate reliable income from risky growth? In their November 2011 paper entitled “The Floor-Leverage Rule for Retirement”, flagged by a subscriber, Jason Scott and John Watson examine a retirement allocation strategy that strictly segregates safe income-generating assets (“riskless” bonds) from potentially income-boosting risky assets (stocks). They designate the safe allocation as the floor portfolio, funded to guarantee a real income level in perpetuity. They designate the risky allocation as the surplus portfolio, which invests all remaining funds to capture a risk premium. If the risky assets perform well, the retiree periodically moves funds from the surplus portfolio to the floor portfolio and thereby increases guaranteed income. In assessing this floor-surplus approach, the authors assume that the riskless bonds generate a steady 2% annual real return and that the risky assets offer a 6% annual risk premium with 18% annual volatility (like the U.S. equity markets over the long run). Based on analysis of several case studies using these return assumptions, they conclude that:

  • An 85% floor allocation and 3X leverage for the surplus allocation are near optimal across a wide range of retirement scenarios. Specifically:
    • Invest 85% of available assets to secure a real or nominal income floor via riskless bonds or an annuity. A real (nominal) income floor implies a lower (higher) initial spending level.
    • Invest the remaining 15% in a 3X-leveraged surplus portfolio.
    • Each year, if the surplus portfolio comprises more than 15% of the combined portfolios, reallocate the excess to the floor portfolio.
  • A number of exchange traded and traditional mutual funds, such as ProShares UltraPro S&P500 (UPRO), offer leverage.

In summary, analysis based on simple assumptions suggests that an 85% allocation to low-risk income-producing assets and 15% allocation to high-risk (3X-leveraged) potentially income-enhancing assets is near-optimal for many retirees.

Cautions regarding conclusions include:

See also “U-shaped Lifetime Allocation to Stocks?”.

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