(The following is the fifth 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.)
Our previous installment in this series introduced two different concepts with regard to setting portfolio objectives for different goals based on their expected target date of need. One method, called the Total Return Method, funds all goals 
from a single portfolio. The Total Return Method has the advantage of requiring less initial assets to achieve multiple goals since the portfolio is often managed with the long-term objective for a longer period of time; thus, exposing it to potentially higher returns. For this reason, since the 1960s, non-profit endowments have generally adopted this method.
We called the second method the Assigned Asset Method. This option assigns a specific portion of one?s assets to a specific goal, resulting in multiple portfolios, one each for each goal, leading to the potential of managing each portfolio with its own unique investment strategies. Many professionals call this method the Bucket method, since each goal has its own ?bucket? of assets assigned to it. The Assigned Asset Method has the advantage of increasing the likelihood of achieving any particular goal, since each assigned portfolio is managed more conservatively as the associated goal?s time horizon moves from long-term to short-term; thus, more quickly reducing the exposure to volatile losses.
Each method has its own pluses and minuses. Given this, does experience reveal whether one method performs better than the other? To answer this question, FiduciaryNews.com interviewed several investment advisers. All investors, and perhaps most importantly 401k plan investors, might want to review the analysis of these professionals to see what might be most appropriate for them.
Noah B. Rosenfarb, Personal CFO/Holistic Wealth Coach at Freedom Wealth Advisors in Short Hills, New Jersey, always uses the Assigned Asset Method for his clients. He says, ?Since my practice has a focus on advising those in need of income, and my clients are typically hesitant to invest in equities because of the recent volatility, bucketing has been a very successful means to get clients to invest in my recommended asset allocation. When I can carve out the next 3 to 7 years of cash needs and show clients that those assets will not be exposed to equity risks, they get a lot more comfortable with having equity risk in the balance of their portfolio.? Rosenfarb recognizing this is just mental account, but he feels the Assigned Asset Method get clients ?to think about money in healthy ways by reducing or eliminating their fear when markets decline.?
Rosenfarb is not alone in this feeling. Richard E. Reyes, Investor Coach at Wealth and Business Planning Group, LLC in Maitland, FL whose clients also seek ?a sustainable and predictable income source,? sees the Assigned Asset Method as a way of ?maintaining peace of mind for a client.? He says, ?the best method is the one that will allow the client to control their emotions during times of extreme volatility and that method is the bucket method.?
Elle Kaplan, CEO & Founding Partner at Lexion Capital Management LLC in New York City, says, ?I prefer bucket strategies. Why? It is a superior strategy in portfolio construction, and in the way that the client psychologically connects with and understands the strategy!?
Damian Rothermel of Rothermel Financial Services, LLC in Portland, Oregon is a firm believer of the Assigned Asset Method, assigning multiple ?buckets? to different time frames. He has three issues with the Total Return Method. ?First,? he says, ?the clients may panic in times of high volatility or negative performance and they want to make significant changes to their allocation to protect their investments and then miss out on any recovery period. Second, the Total Return method usually relies on taking 3% or 4% assuming the investor will have 25 to 30 years in retirement but what if the investor lives longer? The third issue, as most investors age they typically want to take less risk. This can also create major problems if there are not enough assets to continue to draw down.?
Clearly, as these comments illustrate, the reality of behavioral economics acknowledges the practicality of using the Assigned Asset Method. While conservative and more costly than the Total Return Method, it appears best suited to tackle the inevitable conundrum of investor psychology. However, when emotional discipline can be maintained, the advantages of the Total Return Method become a viable option.
?We do both,? says Tim Shanahan, President and Chief Investment Strategist at Compass Capital Corporation in Braintree, Massachusetts. Shanahan explains, ?Quite often, investors will come to us looking for dividend type income and after consultation we would tend to go in the direction of Total Return. Having said that, we also tend to map buckets of money toward specific goals. By following the bucket approach we can more closely fine tune the portfolio to both the risk tolerance and especially the time horizon of the individual goal. We actually call this approach ?goal linked.? It starts with this process [and] continues with a mapping of the clients bucket of money towards that goal and an appropriate strategy, and continues with performance measurement of accumulation against the goal.?
Mitchell E. Kauffman, Managing Director of Kauffman Wealth Services of Santa Barbara and Pasadena, California, agrees with Shanahan. He says, ?In my 30 years? experience, we would employ both approaches to give clients the best of both worlds.?
While David M. Williams, Director of Planning Services for Wealth Strategies Group in Cordova, Tennessee does use the Assigned Asset Method of certain near-term goals and for cash-flow dependent client, he prefers the Total Return Method for all long-term goals. Williams says, ?We don?t determine so much the ending value, but rather the likelihood of all the goals being met from the assets and planned savings. By applying an investment policy statement across all of a client?s assets, we aren?t artificially constrained by time periods that end before the client?s needs end. Assets that are loosely earmarked for one goal may assist in meeting another goal while still meeting its original goal.?
Williams articulates the theory behind the Total Return Method, one that has been successfully employed by colleges, museums and even trusts for decades. But, is there a difference between an institutional investor and an individual investor? Eric Gordon, Assistant Vice President of Communications at The American College in Bryn Mawr, Pennsylvania, explains, ?The Total Return Method is great for endowments as their beneficiaries typically don?t have well-defined and variable consumption needs. In my opinion, the ?Bucket? method is more appropriate for investors who do have well-defined and variable consumption needs. This is what we see in the retirement planning context for most investors. To elaborate, in this context, I prefer the ?Bucket? method because it allows for more precise matching of withdrawals from the portfolio with the consumption needs of the investor. Under the assumption that bonds will comprise a large proportion of the portfolio regardless of whether one chooses the Total Return or ?Bucket? method, interest rate risk can be more effectively immunized through the use of the ?Bucket? method. A secondary benefit is that the ?Bucket? method essentially forces investors to make a careful calculation of their anticipated consumption needs during retirement. Such formalization helps to mitigate the risk of not saving enough for retirement.?
In the end, each investor, especially retirement investors, need to know the nature of their investment goals. Most importantly, they need to recognize the true time horizon of those goals. As Gordon and Williams show, either the Total Return Method or the Assigned Asset Method can be used. Each has its advantages. Each has its drawbacks. Professional providers are aware of these. Individual investors may not be. That?s why it?s so important 401k plan sponsors provide regular investment education, and merely rehash a review of investment options.
Part I: The Easiest Way to Reduce Personal Fiduciary Liability for Plan Sponsors and Other Non-Professional Trustees
Part II: Experts: 3 Common Investor Mistakes All Retail and 401k Investors Should Avoid
Part III: A Better Way to Help 401k Investors Choose Among Options
Part IV: A How-To Guide: Investing Using the Total Return Method or the Assigned Asset Method
Part V: The Choice 401k Investors Must Make Before They Choose
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.
Source: http://fiduciarynews.com/2012/11/the-choice-401k-investors-must-make-before-they-choose/
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