Mitigating Risks Through Liquidity Management
If you’re lucky enough to win the Powerball lottery, you will have to decide if you’ll collect the prize money in one lump sum or in uniform payments over time. You have to choose between a smaller guaranteed payout and a potentially larger, but less certain, outcome. Many pension fund managers face a similar quandary when assessing how to invest portfolio assets: accept certain payoffs in the future for known costs today, or risk a potential shortfall tomorrow for less cost today. A pension fund manager who hopes to adopt a more effective and prudent approach to managing assets should diversify the portfolio using a Building Blocks approach to asset allocation and actively manage the allocation in order to be compensated for the risk required to achieve the inflation and tax-adjusted spending rate.
Unlike pension funds, private clients cannot easily match their asset and liability durations; they have difficulty offsetting pre-defined obligations with relatively certain asset payoffs. While matching asset and liability durations in theory immunizes a portfolio’s spending needs against various market environments, it requires the portfolio owner to make certain contributions today to insure against uncertain outcomes tomorrow (or at some point in the future). This can be an expensive proposition, because it requires a commitment of capital today that could otherwise be invested elsewhere.
Practically speaking, it is difficult for private clients to manage their portfolios in this manner for several reasons: future spending needs are not generally known with any precision, contributions into the portfolio typically cease when the spending phase begins (e.g. retirement date), portfolio growth in excess of the spending needs is typically required (maybe because the portfolio is not fully funded at the time the distribution phase begins or there is an intent to bequeath assets or fund philanthropic causes), and access to long dated bonds constrains the implementation options. Despite these challenges, it is imperative to consider a way to manage the portfolio so that the client is not forced to liquidate assets at precisely the wrong time in order to fund spending requirements.
Let’s look at a client who withdraws 4% from his portfolio each year. The portfolio will need to generate 4% to cover the distribution, plus an amount to cover the effects of inflation and taxes. Taxes and inflation could add another 4% per year to the required return. With interest rates at today’s historically low levels and inflation on the horizon, it is not practical to invest the entire portfolio in 30 year bonds, sit back and clip coupons. Creating a diversified pool of assets that will compensate him for the risk required to achieve the inflation and tax adjusted spending rate is a more prudent approach to managing his portfolio.
Balentine advocates balancing the required distributions and the required risks (necessary to achieve the hurdle rate outlined above) through liquidity management. Liquidity management comes in two forms: transactional and capital requirements. Transactional liquidity refers to the marketability of your investments, while capital requirement is defined as your short-term spending needs. By properly managing the latter, you can afford to forego some of the former. (Elizabeth MacBride discusses how Harvard and Yale faced similar challenges and adjusted their liquidity management programs to provide enough cash to fund operating budget obligations in “How the Harvard and Yale Models Changed to Avoid a Repeat of 2009.”)
Balentine manages portfolios around each client’s distribution requirements and directly links the liquidity reserves (dollar amount held in cash/cash equivalents) to a complete set of risk factors. By immunizing each client’s spending needs over the next one to three years, it affords our clients the peace of mind to withstand the inevitable volatility associated with financial investments.
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