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A How-To Guide: Investing Using the Total Return Method or the Assigned Asset Method

November 13
00:14 2012

(The following is the fourth in a five-part series of articles devoted to helping fiduciaries, especially individual trustees and ERISA plan sponsors, best align investment goals with beneficiaries’ needs.)

For the sake of argument, let’s say any investment with a target date of less than five years should be considered short-term and any investment with a target date of greater than five years should be considered long-term. As we said last time, different advisers and different investors might use a different cut-offs. In this article, it’s not really important what that number of years is, it’s just that we have one, and a solid “5” sounds much more practical than a theoretical “n.”

The individual fiduciary or investor usually has two options with regard to making short-term or long-term projections (although the trust document may sometimes specifically imply which option a fiduciary must use). We will review both of these options. Deciding which option should be used depends on the nature of and the priority of the beneficiary’s collection of goals. For the purposes of our example, we will assume two simple goals: a down payment for a new home ($20,000) in three years and a lump sum retirement goal ($100,000) payable in 10 years. This spreadsheet will determine the smallest possible initial size of the investment portfolio.

The first option treats the investment portfolio as a single portfolio. This requires the investor to take distributions from the total return of the portfolio. We will call this the Total Return Method. Since the Ford Foundation issued its white papers on the subject in 1969, the Total Return Method reflects the current investment methodology of many of today’s leading endowment officers and directors (see “How the Fiduciary Discovered What’s Wrong With Emphasizing Income,” May 25, 2011). The Total Return Method does not compartmentalize the portfolio by assigning a specific set of assets to a specific goal. Instead, the Total Return Method integrates the entire portfolio and treats each goal as a withdrawal from that portfolio. This allows the individual fiduciary or investor the opportunity to fund larger (in terms of dollar value) goals with lesser assets (because, as we shall see, more assets are invested for the long-term over the life of the trust).

Table 1 shows the Total Return Method spreadsheet. The purpose of this spreadsheet is to help identify the minimum initial asset size needed to achieve the selected goals. To do this, we need to first identify the dollar value of each goal and the number of years we have to reach each particular dollar value. Then we work backwards from those dollar values using an assumed long-term rate of return and an assumed short-term rate of return.

Table 1. Total Return Spreadsheet

Year

Long Term

Portfolio

Short Term

Portfolio

Goal #1

Home

Goal #2

Retirement

0

74,585

0

1

80,551

0

2

86,995

0

3

73,955

0

20,000

4

79,871

0

5

86,261

0

6

0

88,849

7

0

91,514

8

0

94,260

9

0

97,088

10

0

100,000

100,000

Column One represents the number of years from today (Year “0”) through the year the last goal will be achieved (in this case, Year “10”). Column Two in the table represents the total value of the long-term portfolio. For long term assets, we have assumed this long term portfolio will have an average return of 8% per year. Please note this assumed rate of return is for illustrative purposes only and may not be appropriate in all investment environments. For sake of comparison, from 1926 to 1996, the S&P 500 has averaged an annual return of about 9.78% according to Ibbotson data.

Column Three represents the total value of the short-term portfolio. For short-term assets, we have assumed this short-term portfolio will have an average return of 3% per year. Again, please bear in mind this rate of return is for illustrative purposes only and should not be considered appropriate in all investment environments. For example, in the high inflation environment of the late 1970’s and early 1980’s, a more appropriate assumption for the short-term rate of return might have been anywhere from 10% to 15%.

Columns Four and Five represent the required distribution of our two sample goals. To keep things simple, we have not adjusted any of these numbers for inflation.

From Table 1, we can see our minimum initial portfolio size is $74,585. In our total return model, we remain invested in long term assets until five years before our final distribution requirement begins. To determine the minimum initial portfolio, we must work backward beginning with the goal that has the most distant target date. In our case, we have $100,000 payable in the tenth year. We quickly calculate that investing $86,261 at 3% for five years yields $100,000. Our initial portfolio must grow to $86,261 by the fifth year. We next need to determine what initial portfolio, growing at our assumed rate of 8% and suffering a withdrawal of $20,000 in year three, will result in a portfolio size of the required $86,261 in year five. Using a spreadsheet model, we have determined this minimum portfolio size to be $74,585.

Table 2 represents a similar spreadsheet. In this spreadsheet, however, we do not assume the Total Return Method. Rather, we used the Assigned Assets Method to reverse engineer our minimum initial portfolio requirements. With this method, each goal is assigned a specific portion of the portfolio’s assets. Each portion must be managed independently and exclusively for each assigned goal. This means each goal’s required distribution is invested in short term assets five years prior to distribution.

Table 2. Assigned Asset Spreadsheet

Year

Long Term

Portfolio

Short Term

Portfolio

Goal #1

Home

Goal #2

Retirement

0

58,708

18,303

1

63,405

18,852

2

68,477

19,418

3

73,955

20,000

20,000

4

79,872

0

5

86,261

0

6

0

88,849

7

0

91,514

8

0

94,260

9

0

97,088

10

0

100,000

100,000

In our example, we only have three years to come up with the required $20,000 home down payment. To reach this $20,000, we need to invest $18,303 for three years with a 3% annual return. From our earlier discussion, we know we need to have $86,261 at the end of year five to attain our $100,000 retirement goal in year ten. An initial investment of $58,708 growing at 8% per year will bring us to our target value of $86,261. Given these figures, our minimum initial portfolio size using the Assigned Assets Method is $18,303 plus $58,708, which equals $77,011.

Compare this to the $74,585 minimum initial portfolio size using the Total Return Method, a smaller minimum portfolio requirement. The Assigned Asset Method requires $2,427 more to achieve the identical goals.

Which method should the individual fiduciary or investor use? In our final segment, we’ll see what financial professionals say and how the specific circumstances of any underlying trust and the specific needs of the beneficiaries might influence this decision.

Interested in learning more about this and other important topics confronting 401k fiduciaries? Explore Mr. Carosa’s book 401(k) Fiduciary Solutions and discover how to solve those hidden traps that often pop up in 401k plans.

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About Author

Christopher Carosa, CTFA

Christopher Carosa, CTFA

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