How to Defend Your Portfolio Against Rising Economic Threats
Tom Idzorek, chief investment officer of retirement, dives into portfolio protection and asset allocation for rising inflation.
Tom Idzorek, from Morningstar Investment Management, which is Morningstar’s affiliated asset-management arm, joinsThe Long View this week to discuss asset allocation, economic risks, and if the 4% rule still holds up in your portfolio.
Here are a few excerpts on portfolio protection, inflation, and human capital from Idzorek’s conversation with Morningstar’s Christine Benz and Jeff Ptak:
Ptak: So, delving into asset allocation further, a key research interest of yours has been the role of human capital in influencing how we invest our financial capital. So, has the pandemic revealed anything about human capital and the way we think that concept ought to be integrated into financial planning and asset allocation? And also, perhaps you can define how you think about human capital in this context.
Idzorek: Right. Yeah. So, again, I guess, I wish that individuals would receive an updated balance sheet that represented what I think of as their total wealth and the nature of what I would – I sometimes referred to as the retirement income liability, recognizing that it may not be a legal liability, but again, most of us have a consumption series even before retirement, and then after retirement that we want a standard of living that we want to maintain. Thinking about the left-hand side of the balance sheet, which is, let’s say, the asset side of the balance sheet, it’s very clear, I think, often what are, what I would say, as our financial capital. But for many investors, their largest single asset is what we refer to as their human capital. And you can think of human capital as being all of the earnings that they’re going to make throughout their lifetime. And again, in our kind of model, we typically focus mostly on the portion of human capital that would be used to eventually pay for retirement. And so, our somewhat nerdy definition of human capital is it’s the mortality weighted net present value of all future earnings that would be used for retirement.
And then if you think about, say, Social Security, or maybe for the lucky few that have access to a defined benefit pension, I think of those as a form of deferred labor income or another flavor of human capital. And then, for most people, we think of human capital, it’s often a little bit more bond like, than stock like, and we arrive at that conclusion by thinking about the nature of the cash flows of that saving series. And again, for most people, it is relatively stable, it’s relatively more safe. And to the degree that people have more human capital, a safe asset that is going to help, whether it’s providing Social Security, a DB, or simply money that is getting saved or converted from human capital into financial capital. Again, this is a wonderful, somewhat safe asset.
And I guess, to tie this back to the part of your question dealing with has the pandemic changed our view of human capital, I don’t know that it’s changed our view on it. I think something maybe that it’s highlighted is that we often assume that people are going to continue to work throughout their lifetime. And it’s something that we’ve seen during the pandemic here is a number of people have, at least temporarily, if not permanently, decided to leave the workforce. And so, our working assumption that most people will be working to some, kind of, retirement age of, say, 65, or whatever it happens to be for them, I’d say maybe need to revisit that a bit.
Benz: Well, I wanted to ask about that, because it does seem like younger people, and this is a huge generalization, but it seems like there’s some embrace of, like, lumpier income streams, that people are not hooking up with an employer and staying there for many years. They’re perhaps a little bit more entrepreneurial. They seem more willing to put up with variability in their cash flows. Do you think that will influence how you make investment recommendations for people in that situation?
Idzorek: I think it probably should. And again, I think that it is – again, we are always trying to learn and improve our models. I will say, it’s probably a good sign that young people have, let’s say, I’ll call it the flexibility, to choose to have that lumpier workstream. Again, this isn’t everybody, of course. But again, that sounds great that one can have the flexibility to choose maybe to take a year off from work where, again, I think that for those of us that are a little bit older, the mindset was, you always had to be working and striving for that savings. But in terms of the way we’re trying to, I would say, design the ultimate financial advisor, ultimate financial planner in a box with our team of PhDs and we want our advice to be as prudent, as suitable as possible and reflect the way investors actually behave. And again, I think this is highlighting a new flavor of behavior.
Ptak: As you know, interest rates have been rising amid higher inflation, and for the first time in quite a while investors are having to deal with losses in both, the stock and bond sleeves of their portfolios. Do you think investors ought to be thinking about adjusting their portfolios so as to better withstand rising rates in inflation should that arise in the future?
Idzorek: Jeff, probably. Again, I guess, to me, the ideal time to have adjusted your asset allocation in your portfolio probably would have been before the increases in interest rates and inflation. And I’d say that that is something that we try to cook into our lifetime asset allocation policies in the way we evolve intra-stock and intra-bond detailed asset allocations within our retirement managed account platform, as well as the target date solutions that we provide. A technique that, I would say, institutional investors, especially, maybe pension plans and endowments that think about funding some sort of liability, a technique that is often used there is liability relative investing, or a flavor of liability relative investing is liability relative optimization. And you can think of that as kind of being an extension of the Markowitz mean-variance optimization, except when you’re running your optimizer, you have constrained the optimizer to hold either an asset or a combination of assets that represent what I would think of as the systematic characteristics of that liability.
And so, if I think about an individual investor, what does their income stream or desired expense stream look like in retirement, to me, most people in retirement have this this thing, it’s almost as if they’ve issued a TIPS bond of some sort, where they have to pay out an ongoing real expense. And you might think of that as one way of thinking about their liability. And then, as one ages, the duration of that bond shortens. And we use this liability relative optimization framework, and we attempt to model the changing nature of the cash flow structure of somebody’s retirement expenses, capturing the interest rate risk and inflation risk associated with that liability. And an outcome of applying that type of optimization is, for somebody that is a nearing retirement or in retirement, you are somewhat attempting to match with your bond portfolio the embedded inflation risk and interest rate risk that would be embedded in that, and you can somewhat offset that with your detailed fixed income portfolio. I’m not saying you can fully offset that. But again, ideally, the right time to have thought about the risks that are inherent in the world that people face, you would want to create your asset allocation in such a way that you would have contemplated raising interest rates and rising inflation prior to actually occurring.
Benz: So, I would just like to ask, so what would the portfolio look like if the goal is to defend against those future threats of rising rates and inflation from a practical standpoint? What are the things that retirees could think about having in their toolkit and acknowledging that they’d want to be preemptive rather than reactive in adding those positions?
Idzorek: Right. If you think about life expectancy, for example, and maybe you’re 60, 65, life expectancy is – it’s relatively long, 30 plus years. And so, the duration of those cash flows is pretty long. And so, one may actually want to have a reasonable amount of duration in their portfolio at age 65, but as move to 70, 75, 85 and the duration of those cash flows becomes lower, you would decrease the amount of duration exposure that you have within your portfolio. So, from an asset allocation, this would be a movement from a portfolio that may have been more intermediate-term bonds and/or some sort of long-term bond exposure from an asset class perspective into something that is probably more a mix of money market, stable value, short-term bond and probably a mix of intermediate bond and phasing out long-term bonds as somebody ages.
And then, thinking about the split between nominal bonds versus TIPS or inflation linked bonds, again – earlier, you’d ask, Christine, about human capital and the nature of human capital. One of the things that we’d like to think about is how do the two big elements of the left-hand side of that balance sheet, your financial capital and human capital, evolve through time. Younger investors, the left-hand side of their balance sheet is dominated by human capital. And I would say, again, earlier I described human capital as being a safe asset. But it also provides an inflation hedge. Most salaries tend to go up, albeit with a lag, during periods of high inflation. And so, younger people who are primarily also invested in equities, have a lot of built-in inflation hedging into their overall total wealth portfolio. But then, in retirement, when on a relative basis, human capital is probably much smaller and the primary mechanism for which people are going to pay for retirement is by drawing down their financial capital, again, I would argue, again, that their asset allocation should evolve in such a way that they are well-positioned to fight the risks that they face and inflation is a growing – well, I want to say, inflation is always a risk that people face. Inflation has been very low for a long time. And now, it is definitely ticking up. Whether it will continue to do so or not, remains to be seen, but it is – high inflation erodes the purchasing power of somebody’s portfolio. And so, in terms of their bond allocation, as somebody is nearing retirement and moving through retirement, I would argue that a larger and larger portion of their fixed income side of their portfolio should be implemented with inflation linked bonds as opposed to nominal bonds.