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What is the right asset allocation for widows?

What is the right asset allocation for widows?

There are many financial issues that a widow needs to address. One of those areas is asset allocation of the investment portfolio. At a high level, asset allocation involves the right mix of stocks and bonds.  At a more granular level, it may include designating the sub-asset classes of stocks and bonds such as the percentage to allocate to short-term bonds, municipal bonds, intermediate bonds, large cap, small cap, international stocks, or emerging stocks, to name a few.  

Traditionally, advisors serving widows take two approaches in determining asset classes. One approach involves going through a risk questionnaire and asking the age of the widow and the other approach involves selling annuities to the widow.

Traditional Risk Tolerance Questionnaires

The more common approach in determining the right mix of stocks and bonds involves asking a series of questions related to one’s risk tolerance. You may have completed one of these questionnaires in the past.  It may ask questions such as “what is your knowledge of investments?”, “what would be your reaction if the stock market decreased by 25% in the last 6 months?”, “what is your time horizon?”, “how do you view losing money versus gaining money?”, etc. While some questionnaires are better than others are, and all are generally done with good intentions, they fall short in a number of respects.

They don’t take into account the individual’s overall financial situation, and such questionnaires do not properly educate the individual on various principals of investing.   Behavioral finance issues – and recency of events in the marketplace and one’s life – may significantly impact the results.  Regardless, these series of questions will lead to what one believes to be the right mix of stocks and bonds for the individual, whether it is defined by a percentage mix of stocks and bonds (e.g., 70% equities and 30% bonds) or an “investor profile” that includes options such as “conservative” or “moderately aggressive”.  

The advisor may be biased in thinking that the widow is risk averse and will automatically put the widow in a mix of stocks and bonds that are similar to the asset allocation mix of all of his or her other widow clients.  This may result in the widow being too aggressive or too conservative for her needs.  

Beware of the Annuity Hawk

Another approach where there are countless stories of financial products being sold is when advisors prey upon a widow’s vulnerability by selling him or her an annuity. The annuity salesperson will usually call on a day when the markets have experienced downtowns, and will preach the stable nature of annuities. While it is true that annuities are generally more stable in the short term than stock markets, the up-front costs (think commission to the salesperson), the ongoing fees inside the annuity, and the relative lack of flexibility that annuities provide generally make these products less advantageous. In some cases, annuities may make sense, e.g., lower cost annuities where the widow has a much longer life expectancy than average and does not have the desire to work with an advisor over the long-term. In most cases, however, annuities only make sense for the financial company and salesperson (whether they call themselves a financial planner, wealth strategist, senior director, etc.).

There’s a Better Way – A Matching Maturity Approach

We feel there is a better approach for widows.  We have adopted the matching maturity approach -- or the asset dedicated approach -- in managing a widow’s portfolio.  At a high level, it involves matching a widow’s cash flow needs with assets that will produce the needed resources in the right amount at the right time.  We start with short-term and long-term financial projections, taking into account a widow’s assets, income, and expenses.  These projections help us calculate the widow’s cash flow needs and the resulting asset allocation decision.

In particular, we purchase bonds that will mature in the year that the widow will need the cash flow.   Not only do we purchase bonds for the next year of needs, but we purchase bonds that will meet the widow’s next 7 – 10 years of cash flow needs, depending on the market and other conditions.

The balance of the investment portfolio is assigned the growth bucket. The growth bucket generally consists of a diversified mix of stocks.  While it is beyond the scope of this article, such mix of stocks generally includes “tilts” to certain asset classes that have historically outperformed other asset classes over the long-term.  Although we tend to favor the passive approach to investing, we believe research supports the value of taking an active approach in selecting the right mix of sub-asset classes within the stock asset class.  The purpose of the growth bucket is obviously for long-term growth which will eventually be used to replace the bonds that mature in those initial 10 years.  We are less concerned about short-term volatility – rather, the goal of the growth bucket is to provide for appreciation that will outpace inflation and will allow the widow investor to be able to meet the ever-increasing living expenses throughout his or her lifetime.

The advantages of this approach are many. First, from a psychological perspective, our widow clients – or, really any of our investment management clients – like the idea of knowing that their cash flow needs will be met with dedicated, safer assets.

Second, this helps minimize or eliminate interest rate risk.  Interest rate risk is the risk that bond valuations decrease in price as the market interest rates increase, thus, it is bond valuations and interest rates that are said to have an inverse relationship. Since we buy bonds and hold them until maturity, that is, the bond lenders pay back the principal of the bond at a particular date in time, we have a relatively high confidence that we will receive our principal back. While we generally don’t buy all treasuries which are generally the safest option available, we do buy a very diversified mix of corporate bonds that are relatively safe while providing higher interest rates than treasuries.

A third benefit is that the cost of such approach does not involve paying high commissions to the financial company which are commonplace with annuities. While the expense ratios or transaction costs should be reviewed and understood, the lower cost structure generally is significantly less than annuities.  

Fourth, this approach potentially allows us to place the longer-term assets in a bucket what they are meant for – growth!  Because the time horizon is longer, the stocks in the growth bucket may not need to be sold when the stock market is down since the cash flow needs are met with the liquidity and matching buckets.  One can be patient with the growth bucket.  By having a longer term perspective on this growth bucket may allow us to take smarter, calculated risk with these equities.  We are less concerned with short-term volatility, but we are still concerned with long-term volatility and long-term potential growth rates. This rationale leads us to tilt our allocations to certain asset classes over others.

Integrated Approach

So, determining the right asset allocation should not be standard for all widows or standard for all widows of a certain age range.  The proper asset allocation is dependent on the widow’s unique financial situation and overall goals.   Of course, deciding the mix of stocks and bonds should not be reviewed in isolation.  If your advisor is working with you properly, income tax issues, life planning goals, estate planning, and numerous other financial issues will be addressed in an integrated manner.  At Oasis Wealth Planning, our multi-disciplined team of financial advisors do indeed take a holistic approach in serving widows.