Introduction
Trusts, foundations, endowments, and retirement accounts share a key challenge – they require regular withdrawals to fund expenses or donor goals. This poses a unique challenge from an investment management perspective, as it necessitates careful investment portfolio design to maximize asset lifespan. The strategy must facilitate ongoing distributions without impairing long-term capital growth.
Why does this matter? Simply put, if an investment strategy isn’t carefully designed to support a sustainable withdrawal rate, there’s a risk that the account will be depleted far earlier than expected.
We wrote this article to outline our portfolio design process,, and to hopefully provide a helpful resource for anyone interested in learning more about this topic.
Who is This Relevant For?
This process is intended for any entity or account that has regular required distributions, such as:
- Trusts
- Foundations
- Endowments
- Retirement Accounts
The Challenge
The primary portfolio design challenge is balancing returns with volatility. It’s tempting to assume that ignoring volatility to focus on maximizing returns is ideal to spur growth. However, for accounts requiring withdrawals, this heightens sequence risk – the danger of poorly timed distributions permanently impairing capital. Managing this risk while generating strong investment returns is crucial – and difficult.
Consider two portfolios, A and B, both starting with $100 in assets and mandated to distribute $10 annually on June 30th. They both hold investments that generate 10% returns annually. However, Portfolio B experiences a temporary 50% drawdown in the middle of each year, while Portfolio A experiences no drawdowns at all. Ultimately, they’re producing the exact same annual returns, but with very different intra-year volatility. So how does this impact the life of the portfolios?
Surprisingly, at the end of year 5 Portfolio A will have $94 in assets while Portfolio B will only hold $27 in assets. The reason, not always immediately intuitive, is that Portfolio B is forced to sell assets each year when they’re half-price in order to fulfill its $10 distribution, inadvertently locking in those losses and reducing the amount of capital available to continue compounding each year. In the long term, Portfolio A will be able to sustain it’s distribution until year 2048 compared to Portfolio B which runs out of assets in 2029. Admittedly, this is an extreme example, but it serves to illustrate the point that volatility is a real cost.
Ultimately, two key portfolio design objectives emerge:
- Mitigating volatility to minimize sequence risk
- Generating adequate long-term returns to support sustainability
The solution lies in portfolio design optimization – targeting an ideal volatility/return profile to give the highest probability of lifespan maximization. This requires balancing defense with growth.
The Guide: Developing a Bespoke Risk-Adjusted Strategy
Step 1: Define the Withdrawal Rate
Instead of selecting investments, and then calculating a sustainable withdrawal rate, we’re going to define the withdrawal rate first based on cash flow needs. This top-down approach enables tailored portfolio construction to support distributions.
Determining the requisite withdrawal rate is critical for alignment, and it’s one of the core steps in our financial planning process. In the case of an endowment or a retirement account, this could be based on the required expenses that need to be covered. For a charitable foundation, the withdrawal rate may be a specific amount that’s required by the IRS to be distributed each year.
Ultimately, we want to quantify the annual distribution as a percentage of total assets. The withdrawal rate serves as a keystone of our investment strategy design. By conscious alignment of portfolio objectives and client outcomes, we construct bespoke portfolios to facilitate lasting success.
Step 2: Map Out the Risk/Reward Menu (aka the Efficient Frontier)
Next, we need to build a spectrum of model portfolios with varying asset allocations, essentially creating an investment “menu” spanning the risk/reward spectrum. Our goal here is to provide a wide variety of options that we can test in our next step in order to hone in on the specific portfolio that has the greatest success probability.
To build this menu, we use portfolio optimization software. We define a target level of volatility (starting low) in addition to a few other parameters, and then backtest for an asset allocation that produces the highest level of returns at that specific volatility level. We then repeat this process, backtesting a wide range of model portfolios across the risk spectrum. This produces a menu of thoughtfully selected investment blends projected to pair well with our client’s needed withdrawal rate. It’s like a menu showcasing flavorful portfolio recipes tailored to specific investor tastes and goals.
The end result? An efficient frontier highlighting smart investment combinations to suit different preferences for risk versus potential reward.
Step 3: Identify Our Optimal Portfolio
Armed with our menu of “efficient frontier” options, we now need to identify the optimal portfolio – defined as having the highest probability of maintaining the target withdrawal rate over time.
To determine this, we use an in-house Monte Carlo simulation tool. In short, it uses an algorithm to simulate each potential portfolio’s performance over a defined timeframe (say, 30 years) – and then repeats that process over a thousand times. This rigorous stress testing offers a robust view of how each option may fare.
We can then score the portfolios on metrics like average ending balance, success rate, Sharpe ratio, and more. This process reveals the specific portfolio asset allocation with the highest expected odds of withdrawal sustainability and portfolio longevity – the optimum recipe balancing risk and return for the client’s needs.
Other Portfolio Construction Considerations
With an optimized asset allocation in hand, portfolio construction centers on the client’s specific needs and philosophy. We select securities aligning with their circumstances – tax status, account type, values, and so on.
Maintaining diversification is key. We ensure low intra-sector correlation and leverage in-house analysis to identify mispriced securities with return potential.
Additionally, we implement strategic portfolio overlays – strategies honed over years – to further manage risk and enhance returns. Examples include covered call strategies, securities lending, volatility dampeners, and more.
The end result is a tailored portfolio blending an optimal asset mix with personalized selections and strategic overlays – truly customized for each investor’s singular objectives.
Conclusion
The process of designing investment portfolios for portfolios with regular required distributions is a nuanced and critical undertaking. The central challenge lies in striking the right balance between returns and volatility to ensure the longevity of the assets. We’ve outlined the strategic approach we take, emphasizing the importance of defining withdrawal rates upfront, constructing a risk/reward menu through backtesting, and identifying the optimal portfolio using Monte Carlo simulations. The example comparing Portfolio A and B underscores the real cost of volatility and highlights the necessity of diligent portfolio construction. By focusing on a bespoke risk-adjusted strategy, investors can enhance the likelihood of maintaining the required withdrawal rate over the long term, significantly increasing the sustainability and success of these specialized investment vehicles.
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About Chris Stevenson, CFA®
Mr. Stevenson is an investment advisor representative of and offers investment advisory services through Forrest Financial Partners, LLC, a registered investment adviser offering advisory services in the State of Connecticut and other jurisdictions where registered or exempted. Tel: 860‐222‐0232
Nothing in this article constitutes investment advice and all content is subject to the Legal and Disclaimer Policy of Forrest Financial Partners.
