Financial advisors serving the retirement market will increasingly encounter clients with substantial investments in target-date mutual funds that automatically adjust unitholders’ asset mixes to become more conservative as those clients approach retirement age.

As a result, advisors will need tools to evaluate the suitability of these asset allocations and age-related glide paths to meet clients’ retirement income needs.

But truly optimal asset allocation depends not only upon age, but also upon the ratio of a client’s portfolio size to the client’s desired spending in retirement, according to American software developer Gordon Irlam in a recent Journal of Personal Finance article entitled “Portfolio Size Matters.”

Of course, the point of target-date funds is to nudge unsophisticated investors and participants in employer-sponsored defined-contribution plans in the right direction.

However, rather than simply adopting such mechanical glide paths, Irlam believes advisors need to incorporate what he refers to as “relative portfolio size” (RPS) – the portfolio size relative to the expected retirement withdrawal amount – into calculations and recommendations.

To this end, Irlam has developed an asset-allocation tool called the “optimal portfolio algorithm,” which doesn’t generate potential future returns from a probability distribution; instead the algorithm uses returns drawn from the annual historical record.

Sustainable withdrawals

The algorithm computes everything in terms of RPS. It isn’t absolute portfolio size that seems to matter, but the portfolio size relative to the annual retirement withdrawal amount and age, Irlam suggests.

For those advisors used to thinking in terms of sustainable withdrawals, the RPS during retirement is simply 100 divided by the withdrawal rate. For example, if the portfolio size is $500,000 and the annual retirement withdrawal amount is $25,000, then the withdrawal rate is 5% and the RPS is 20.

To assist with customized calculations, Irlam has created a web page ( that enables advisors to develop their own scenarios before introducing them to clients.

Irlam’s calculations are made using dynamic programming, which works backward to determine the optimal asset allocation at a particular age after accounting for the optimal strategy for subsequent years and portfolio sizes. The algorithm also is able to factor in the probability of a client being alive at each age when calculating the correct mix.

Stock allocations

Success rates are naturally higher when the RPS is higher (implying the ability to use a lower withdrawal rate to meet a client’s goal). Thanks to sequence-of-returns risk, the highest RPS is needed in the years around the retirement date and immediately after.

Optimal stock allocations decrease as the RPS gets larger at any particular age. Those clients able to use quite low withdrawal rates to meet their goals and who have no bequest motive can make do with a low stock allocation.

Conversely, those with a low RPS will maximize the chances of meeting their spending goals by having a more aggressive stock allocation.

In general, Irlam estimates, a relatively small portfolio should favour stocks, whereas a medium-sized portfolio should be balanced. A relatively large portfolio should favour bonds, provided clients are indifferent to leaving an inheritance. If they care about legacy issues, a more balanced mix is more appropriate.

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