The way that an investment portfolio is allocated among asset classes has a significant effect on a plan. However, there is art as well as science in specifying target asset allocations in retirement income planning and management. Below we discuss several issues to keep in mind when developing your approach to asset allocation in Income Lab.

Asset Classes, not Holdings

Like all tools for medium- and longer-term financial planning, Income Lab's modeling and analysis depends on data and assumptions of how asset classes, not individual hƒoldings, behave. The reasons for this are practical:

Developing and Managing Capital Market Assumptions

The time that would be required to develop, evaluate, and manage capital market assumptions for hundreds or thousands of possible holdings, including average returns, standard deviations, and correlations with all other possible holdings, is massive, making this impossible in practice.

Diversification

If clients hold diversified portfolios, the effects of an individual holding is swamped and smoothed over time by other holdings in the same asset class, meaning the extra work needed to produce holdings-level capital market assumptions would not be worthwhile for diversified portfolios.

Availability of Historical Data

Historical data is almost always used in developing capital market assumptions. (For all its faults, historical data is still the only real data we have on investment performance.) Furthermore, Income Lab includes many ways for financial advisors to use and view history. These include our "Historical" analysis method, the "Historical Analysis" graph, and the Retirement Stress Test. All of these require the use of historical returns data. But many holdings do not have much history. We may be interested in how a plan would react to 1970s inflation, but the answer to that question won't involve a look at the performance of Tesla stock in that period!

How to Match Actual Target Allocations to Income Lab Asset Classes

As part of our commitment to providing comprehensive and robust tools for retirement income planning and management, Income Lab continually seeks ways to expand our asset class modeling. However, advisors will occasionally find that for some or all clients, they are using an asset class or investment strategy that isn't available on the Income Lab app. In this situation, the best practice is to use the "most similar" available asset class as a stand-in. 

To determine a good stand-in, explore the default capital market assumptions (real returns, standard deviations of returns, and inter-asset correlations) for our available asset classes. CMAs for Traditional Monte Carlo are based on the most recent 50 years of real returns data for each asset class, so this is a good place to start. A review of this list should reveal a reasonable alternative.

For more information on Income Lab's default CMAs, see How does Income Lab create its default capital market assumptions?

If your approach to investing in a particular asset class warrants different capital market assumptions, you can set more suitable assumptions by toggling the "Default | Custom" chooser to "Custom" and being sure to use Traditional Monte Carlo or Regime-Based Monte Carlo in your planning.

Of course, it can be disappointing or frustrating to set target allocations in planning tools that don't quite match your approach on the ground. However, keep in mind that all planning involves estimates and assumptions, and a mismatch between assumptions and actual future experience is almost inevitable. (See this article from Kitces.com for more on forecasting errors in retirement planning.) 

This is one of the reasons that adjustment-based planning and plan monitoring is so valuable: it allows advisors and clients to make sure they are always up-to-date. If portfolios behave better than expected, clients will see this when their plan shows an increased spending capacity or better performance in the Retirement Stress Test. The opposite is true when actual experience lags assumptions.

Finally, it is also important to note that small differences in asset allocation (for example, a percentage point or two shift between similar asset classes) are unlikely to yield drastically different results in spending capacity or guardrails for medium- and longer-term retirement income plans.