There is a better way to do asset allocation for income generation.
You are used to seeing volumes of literature on “the efficient frontier” and Modern Portfolio Theory which has guided financial planners and financial planning software for decades on having clients fill out questionnaires and developing an asset allocation portfolio. Because of this well-chronicled approach, you think this is the only way to go. Perhaps there is a more practical way.
Let’s revisit this. If the goal is long term, persistent income, why not instead reverse engineer the needed income stream and then fill out the growth exposure?
How do we do this?
Let’s take a client with a net worth of $3 million that includes personal or joint (married) account money, IRAs, Roth IRAs, a rental property and home. The first thing we do is subtract out the house. It’s worth $1 million, so we now have $2 million to work with.
From this breakdown, we know they are Accredited Investors, meaning they can legally buy “Alternative Investments.”
Our first question is what is their required income, and then we gross it up. We gross it up for all those things you didn’t plan on and things that are more malleable, like taxes. Maybe we add an extra 20%. This number goes in the numerator of the equation, and that net worth number from above is the denominator. For the purposes of this exercise and things that will come later, let’s say that what you need right now is $80,000.
This is the magical 4% that has become so controversial with financial planners. It is controversial because its origins involved the IRA account’s initial Required Minimum Distribution level. But in the financial planning community with its passion for index funds and little comfort for private equity and debt have deemed this 4% rule obsolete. It is not, as we will see.
But I digress. Here is where we consult the long-term returns for stocks and bonds, which has been documented by the Ibbotson charts. Long-term returns for stocks is somewhere around 10%, much more lately, but that will cycle away at some point. Long term for corporate bonds sits around five percent. So it becomes obvious that a mix of stocks and bonds can get you to four percent. Not every year, but who buys either stocks or bonds for one year? Use a five- or ten-year rolling average and make sure this is long term money.
Earlier in this paper we referenced “Alternative Investments.” Now, this can encompass many things, so we are specifically referring to private equity and credit. With private equity, it is well-known that returns should be 2-3% higher than public markets. This is because you are tying the money up for 10-12 years–most likely 12. With private debt, you are looking at more like eight percent income. Again, there is an illiquidity bonus that some people lately are being reminded exists. But by my calculations, so long as the time horizon is correct, I have the opportunity to juice up my income from the 5% corporate bonds or municipal equivalent to more like six percent, and our growth rate on the blended portfolio should be in the high single digits, offering me the ability to raise my income with inflation.
When you blend all of this together, stocks, bonds, private equity and private debt, you potentially can get to that 4% rule.
Now let’s fold in another category of investing: real estate. The tax code smiles on real estate investors. They can deduct interest rate from loans and depreciation of the assets they own off their taxable income. The scope of this subject goes well beyond what I am writing in this paper, but the benefits are there for anyone creative enough to address them. The real estate you want to invest in pays you rent. If you do not want to deal with the day-to-day issues of tenants, hire a property manager! Sure, they cut into your income stream, but you still get a meaningful amount of income as well as those much-appreciated tax write offs.
So what do you have at this point?
You have interest income from bonds, qualified dividends from stock and rent from real estate. You have income from private credit and potential liquidity events from your private equity. Returns ought to be above those of the 10% and 5% referenced above. The write-offs from your real estate depreciation ought go far to mitigate any capital gains you incur as the years go by.
But what kind of risks have you created for yourself?
Every single one of these asset classes has risk. Stocks generally have a down market one year in every four. Bond prices will go down when interest rates go up. Private equity funds routinely have a dozen or more companies and two or three of them are duds. There will be years when you cannot get to your private credit holdings because of gating restrictions. You will lose and gain renters and there will be expenses with the real estate. But there are ways to mitigate all of these risks. First, you have spread your investable cash across many assets with different performance cycles. Second within the asset classes you have diversification. Third, between insurance and thoughtful titling you have protected yourself from the unexpected.
We began this paper asking for the proper asset allocation. This approach is practical and it doesn’t require having all of your assets under the supervision of one person or using an esoteric theory. The asset allocation just develops as you build out the investment structure. It just happens.