Investment Policy the Time Frame

Investment Policy

The time frame for the accumulation of funds is 35 years (65-30). At that point, Paul will be 37 years old. The total time frame for care for Paul is going to be 48 years (85-37). One question not addressed is the need that John and Mary have for their own retirement. At present, it is assumed that they will live off of social security and any pensions, rather than from their own savings, but it would be best to ask the clients that.

The first thing to assess is the level of risk aversion that these clients are going to have. Normally, a long time frame implies that a fairly high amount of risk can be taken with the portfolio, but in this case there is likely to be a higher degree of risk aversion because the money is being used to care for their son, who is not expected to have any earning capacity of his own. While the actual level of risk aversion needs to be determined, it is assumed that it will be lower than for a retirement fund, because Paul will need this money to live.

The present day cost of assisted living is $42,000 per year. In 35 years' time, this will be $118,183 annually. By the time Paul is 85, which is 83 years from now, this amount will be $488,358. The total need during the time from when John and Mary turn 65 until Paul turns 85 will be $12,827,575.

An important consideration is how large this fund needs to be when Paul enters assisted living. The reason for this is that at that point, the clients (John and Mary) will be retired, and therefore unable to make further capital investments into the fund. The fund will need to generate its own income at that point, but the client's level of risk aversion is going to be much higher as well because there are no further opportunities to add to the fund. Thus, the fund will be steadily depleted over this time, and need to earn on fixed income interest enough money for the fund to last 48 years. Building a fund for 35 years that has to last 48 years is a major challenge.

It is assumed that John and Mary are going to make monthly contributions to this account during their working lives. These contributions will be separate from Paul's current medical bills, whatever caregiver costs there are today, and whatever disruption Paul represents to the earning potential of John and Mary. The objective here is simply to calculate how much John and Mary will need to contribute on a monthly basis to this fund, so that they have that information.

There are a few basic assumptions that go into this calculation. The first such assumption is with respect to the rates earned on different categories of investment. It is assumed, based on Treasury data, that the long run average Treasury rate (or risk-free rate) is 3.3%. Corporate bonds are assumed to have a 1.5% premium, equities a 7% risk premium. Cash is assumed to pay 0.5%. So the rates on corporate bonds are 4.8%, and 10.3% for equities.

The next step is to determine the best asset allocation. Over a 35-year time frame, equities are the best value because they rise fairly consistently in the long-run, although they are unreliable in the short run. For the first 25 years, the portfolio can be mainly in equities (75% equities, 15% corporates, 10% Treasuries). For the years 25-35, the asset allocation will start to move towards safety (30% equities, 40% corporates, 30% Treasuries). To determine how large the monthly payments into the fund need to be, we must work backwards from our determination of how much the portfolio needs to be worth in 35 years.

Part Two

At 35 years, all equities will be purged from the portfolio to maximize safety (10% corporates, 70% Treasuries, 20% cash). This means that the fund will generate an average return of (0.48+2.31+.1) = 2.89%

Using Excel, it is determined that the value of the portfolio when John and Mary retire and Paul enters assisted living needs to be $5,775,134. With that level, the portfolio will have money until Paul turns 85, at which point the portfolio will no longer have value. The assumption here is that the payments for the assisted living around going to be held in cash, so there is a need for 20% of the portfolio to be cash, and much of the rest is Treasuries so that it is liquid. Maturities will need to be staggered so that there is a current portion reaching maturity each year, to avoid having to sell below par, thereby removing on key risk factor at the stage when the portfolio has the highest degree of risk aversion. For this reason as well, bond funds cannot be substituted for bonds, because they fluctuate in value with the prevailing interest rates.

Working backwards from the $5,775,134 figure, we need to determine how much John and Mary need to invest in this account. The return during the first 25 years will be (.75*10.3 + .15*4.8 + .1*3.3) = 7.725 + .72 + .33 = 8.775%. The returns from years 26-35 will be (.3*10.3+.4*.48+.3*3.3) = 3.09+1.92+.99 = 6% .

The annual contributions need to be $36,972. This equates to $3,081 per month. Note that compounding is not assumed to be monthly in this example. There are three reasons for that. The first is that fixed income does not pay monthly. The second is that equities do not follow a linear compounding pattern either. The third is that we want to be conservative in our estimates. Assuming compounding would lower the monthly contribution required, and could lead to shortages in the last few years of the portfolio if the assumptions about the returns do not hold.

With respect to specific asset allocation, it is important to keep in mind that the longer the time frame, the riskier the portfolio will be, in order to build up the equity. Within the asset classes, there will also need to be more risk in the earlier years. So in the first few years, equities can have a higher percentage of small cap and some international. As the portfolio moves closer to year 35, the equities should be more secure. This will affect the earnings of the portfolio, but since the timing of market moves is not known, an average rate has been used.