How to invest funds that will be reduced annually within 25 y period ?

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Topic Author
Spgold
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Joined: Fri May 10, 2019 4:52 am

How to invest funds that will be reduced annually within 25 y period ?

Post by Spgold »

Hello,

Here is the situation I am facing. One of our partners is cashing out and the rest of us are purchasing his shares.

My payment for this purchase will be in annual payments with a time horizon of 25 years. The total amount I will have to contribute is currently at my disposal and payments schedule will be as follow

The first year (end of 2022) 3% of the agreed total amount. Then each year there will be an annual increase of 2% in payments.
For example end of 2023 I will have to pay 3,06% , end of 2024 3,12% etc …

In other words the first year 3% payment of the agreed amount, which will compound by 2% each year until the end of the 25 year period when all capital is finally depleted.

My question is this :

How should I address this, since I do not want to “budget” this annual obligation and pay it off from every year’s income - especially because I have the full amount currently at my disposal and taking the long time horizon (25 years) into account ?

Should I address it are a “retirement scenario” where for the first year I will be withdrawing 3% and from the second year on my needs will increase by 2% compared to previous years need ?

If so, how should I invest this capital regarding AA ?

I would prefer to keep this case separate from all other investments, emergency funds, etc and rather look at is as a separate portfolio built for a specific reason …

Thank you in advance.
jebmke
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Re: How to invest funds that will be reduced annually within 25 y period ?

Post by jebmke »

What would you do if this was a mortgage?
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Spgold
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Re: How to invest funds that will be reduced annually within 25 y period ?

Post by Spgold »

jebmke wrote: Mon Jan 17, 2022 5:48 am What would you do if this was a mortgage?
I would pay it right away, but since this is not an option and the amount cannot be held in cash in a bank account due to the protection scheme, I am looking for alternatives.

Also note there is no interest to be paid to the amount agreed that will be paid off within the next 25 years.
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Raybo
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Re: How to invest funds that will be reduced annually within 25 y period ?

Post by Raybo »

Could you ladder out CDs or Treasury bonds similar to a liability matching portfolio for the amount due each year? Finding CDs that go out that long will be hard (10 year max?) and interest rates are low (possibly negative) on some Treasuries. But, it would solve your problem.
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muffins14
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Re: How to invest funds that will be reduced annually within 25 y period ?

Post by muffins14 »

How much is the amount, how much are your current expenses, and how much do you have left each month after taxes?

If it were me, and say I had 10k per month that I saved in a brokerage and this new amount was 2k per month, I would probably just cash flow it.

If it’s too high to cash flow, perhaps I’d cash flow 50% if it and withdraw the rest from my portfolio. Maybe invest that money as a 60/40 stock/bond portfolio. The dividends would cover a lot of the amount
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Topic Author
Spgold
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Re: How to invest funds that will be reduced annually within 25 y period ?

Post by Spgold »

Raybo wrote: Mon Jan 17, 2022 8:09 am Could you ladder out CDs or Treasury bonds similar to a liability matching portfolio for the amount due each year? Finding CDs that go out that long will be hard (10 year max?) and interest rates are low (possibly negative) on some Treasuries. But, it would solve your problem.
Hi, I am in Europe so no Treasuries here and € gov bonds is a no for me due to Italy having a high stake in them.

CDs do not go so far out as you correctly pointed and current interest rate would be ca. 0,1 % before tax. In addition I would have to go to several banks in order to be covered by the protection scheme.
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Spgold
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Re: How to invest funds that will be reduced annually within 25 y period ?

Post by Spgold »

muffins14 wrote: Mon Jan 17, 2022 8:58 am How much is the amount, how much are your current expenses, and how much do you have left each month after taxes?

If it were me, and say I had 10k per month that I saved in a brokerage and this new amount was 2k per month, I would probably just cash flow it.

If it’s too high to cash flow, perhaps I’d cash flow 50% if it and withdraw the rest from my portfolio. Maybe invest that money as a 60/40 stock/bond portfolio. The dividends would cover a lot of the amount
It’s 500k. Current expenses are taken care of and already contribute to a 60/40 portfolio.

That amount was very recently acquired from selling a property and will be spent as described in the original post within the next 25 years.
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ResearchMed
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Re: How to invest funds that will be reduced annually within 25 y period ?

Post by ResearchMed »

Spgold wrote: Mon Jan 17, 2022 10:42 am
Raybo wrote: Mon Jan 17, 2022 8:09 am Could you ladder out CDs or Treasury bonds similar to a liability matching portfolio for the amount due each year? Finding CDs that go out that long will be hard (10 year max?) and interest rates are low (possibly negative) on some Treasuries. But, it would solve your problem.
Hi, I am in Europe so no Treasuries here and € gov bonds is a no for me due to Italy having a high stake in them.

CDs do not go so far out as you correctly pointed and current interest rate would be ca. 0,1 % before tax. In addition I would have to go to several banks in order to be covered by the protection scheme.
Are you in the UK? It seems that the protection scheme there covers up to 85k pounds. (I'm guessing UK rather than other parts of Europe due to your use of "scheme", but I could obviously have guessed wrong.)

If so, it wouldn't take too many banks... it's not like you have 10 or 50 million pounds to allocate, although it wouldn't necessarily be a "bad" problem if you had that. :happy
I was going to ask if there are services that take an aggregated amount and parcel them out, such as exists in the US to be used for FDIC protection for large sums. But if you need only a handful of separate accounts, that seems doable, especially as mostly they would just sit there. The withdrawals for your payments only needs to come from one each year, until the end, when you could group the remaining amounts of each.

But you used the term "invest", so are you actually not interested in a relatively low rate fixed income type of holding at all? I'd think that would be riskier; would you really feel comfortable holding riskier investments for this purpose? OTOH, 25 years could yield some nice compounding. How bad would your situation be if a noticeable percentage of the ~500k were to be lost?

RM
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1squirrel
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Re: How to invest funds that will be reduced annually within 25 y period ?

Post by 1squirrel »

Spgold wrote: Mon Jan 17, 2022 5:40 am
The first year (end of 2022) 3% of the agreed total amount. Then each year there will be an annual increase of 2% in payments.

Should I address it are a “retirement scenario” where for the first year I will be withdrawing 3% and from the second year on my needs will increase by 2% compared to previous years need ?
Hi
I think your idea to address this as a 'retirement scenario' is the way to go.
It is basically a 3% withdrawal with a fixed 2% inflation.
That would be a very conservative & safe rate to withdraw.

I would choose a stable, low risk portfolio like a butterfly, a permanent portfolio or all weather approach
with or without globalization according to your taste.
Here are some ideas: https://portfoliocharts.com/2019/08/20/ ... vestments/

It would give you 25 years of experience managing a retirement account as a bonus.
Out performance of the 3% + "inflation" is yours to keep as well.
So you kind of "inherit" the remains of the "retirement portfolio" from yourself after 25 years.

Congratulations.
Mike Scott
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Re: How to invest funds that will be reduced annually within 25 y period ?

Post by Mike Scott »

Just invest it into your portfolio. Each year you can use cash flow or a withdrawal to cover the payment.
muffins14
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Re: How to invest funds that will be reduced annually within 25 y period ?

Post by muffins14 »

Mike Scott wrote: Mon Jan 17, 2022 8:50 pm Just invest it into your portfolio. Each year you can use cash flow or a withdrawal to cover the payment.
Yeah if it were me, I’d keep it in a 70/30 or even 100% stock allocation and just pay the 3% per year plus inflation.

Again the dividends will cover a good chunk of the amount, and you can cashflow the rest while getting good growth of your 500k. Keeping it all in cash or bonds is a pretty big opportunity cost, at least to me
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Valuethinker
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Re: How to invest funds that will be reduced annually within 25 y period ?

Post by Valuethinker »

Spgold wrote: Mon Jan 17, 2022 5:40 am Hello,

Here is the situation I am facing. One of our partners is cashing out and the rest of us are purchasing his shares.

My payment for this purchase will be in annual payments with a time horizon of 25 years. The total amount I will have to contribute is currently at my disposal and payments schedule will be as follow

The first year (end of 2022) 3% of the agreed total amount. Then each year there will be an annual increase of 2% in payments.
For example end of 2023 I will have to pay 3,06% , end of 2024 3,12% etc …

In other words the first year 3% payment of the agreed amount, which will compound by 2% each year until the end of the 25 year period when all capital is finally depleted.

My question is this :

How should I address this, since I do not want to “budget” this annual obligation and pay it off from every year’s income - especially because I have the full amount currently at my disposal and taking the long time horizon (25 years) into account ?

Should I address it are a “retirement scenario” where for the first year I will be withdrawing 3% and from the second year on my needs will increase by 2% compared to previous years need ?

If so, how should I invest this capital regarding AA ?

I would prefer to keep this case separate from all other investments, emergency funds, etc and rather look at is as a separate portfolio built for a specific reason …

Thank you in advance.
So basically this is an inflation-indexed annuity?

It's certainly possible to buy fixed period annuities. However the charging and investment strategies can often be very opaque.

The main attraction of an annuity (Single Premium Income Annuity - SPIA to our American friends) is the longevity insurance embedded in it. Capping that eliminates the point of the product, to my mind.
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galeno
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Re: How to invest funds that will be reduced annually within 25 y period ?

Post by galeno »

Inflation-indexed government bonds in or linked to your home currency?

E.g. our currency, the CRC, is linked to the USD. Thus, I'd buy a LMP = 25 yr ladder of TIPS.
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alex_686
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Re: How to invest funds that will be reduced annually within 25 y period ?

Post by alex_686 »

I think you are asking the wrong question. Instead, take a look of Constant Proportion Portfolio Insurance (CPPI), a rebalancing technique.

https://en.wikipedia.org/wiki/Constant_ ... _insurance

Basically you are in a situation where you MUST minimize downside risk (you must make the minimalize payments) while wanting to maximize the upside return. The idea is that you find a mixture of risky (equities) and low risk (bonds) assets. The above framework works very well in this situation. It is the cornerstone of pension investing where you are trying to mix required pension payouts while trying to maximize returns in the equity market.
Former brokerage operations & mutual fund accountant. I hate risk, which is why I study and embrace it.
Valuethinker
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Re: How to invest funds that will be reduced annually within 25 y period ?

Post by Valuethinker »

alex_686 wrote: Tue Jan 18, 2022 3:35 pm I think you are asking the wrong question. Instead, take a look of Constant Proportion Portfolio Insurance (CPPI), a rebalancing technique.

https://en.wikipedia.org/wiki/Constant_ ... _insurance

Basically you are in a situation where you MUST minimize downside risk (you must make the minimalize payments) while wanting to maximize the upside return. The idea is that you find a mixture of risky (equities) and low risk (bonds) assets. The above framework works very well in this situation. It is the cornerstone of pension investing where you are trying to mix required pension payouts while trying to maximize returns in the equity market.
Alex

You really add incredible value to this Forum.

Thank you

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Topic Author
Spgold
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Re: How to invest funds that will be reduced annually within 25 y period ?

Post by Spgold »

alex_686 wrote: Tue Jan 18, 2022 3:35 pm I think you are asking the wrong question. Instead, take a look of Constant Proportion Portfolio Insurance (CPPI), a rebalancing technique.

https://en.wikipedia.org/wiki/Constant_ ... _insurance

Basically you are in a situation where you MUST minimize downside risk (you must make the minimalize payments) while wanting to maximize the upside return. The idea is that you find a mixture of risky (equities) and low risk (bonds) assets. The above framework works very well in this situation. It is the cornerstone of pension investing where you are trying to mix required pension payouts while trying to maximize returns in the equity market.
That sounds very interesting, although I do not quite understand how I could implement this especially the multiply factor…. What I do know for sure is that I have no access to zero coupon bonds.

The only other solution I see if I get this right is to create a very conservative portfolio such as the permanent one, unless I am missing something else.
lasp506
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Re: How to invest funds that will be reduced annually within 25 y period ?

Post by lasp506 »

Spgold wrote: Mon Jan 17, 2022 5:40 am Hello,

Here is the situation I am facing. One of our partners is cashing out and the rest of us are purchasing his shares.

My payment for this purchase will be in annual payments with a time horizon of 25 years. The total amount I will have to contribute is currently at my disposal and payments schedule will be as follow

The first year (end of 2022) 3% of the agreed total amount. Then each year there will be an annual increase of 2% in payments.
For example end of 2023 I will have to pay 3,06% , end of 2024 3,12% etc …

In other words the first year 3% payment of the agreed amount, which will compound by 2% each year until the end of the 25 year period when all capital is finally depleted.

My question is this :

How should I address this, since I do not want to “budget” this annual obligation and pay it off from every year’s income - especially because I have the full amount currently at my disposal and taking the long time horizon (25 years) into account ?

Should I address it are a “retirement scenario” where for the first year I will be withdrawing 3% and from the second year on my needs will increase by 2% compared to previous years need ?

If so, how should I invest this capital regarding AA ?

I would prefer to keep this case separate from all other investments, emergency funds, etc and rather look at is as a separate portfolio built for a specific reason …

Thank you in advance.
Immediate annuity with 2% fixed COLA adjustment for a 25 year period certain will do.

Checkout https://www.immediateannuities.com/
You may need to talk to them on the phone
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celia
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Re: How to invest funds that will be reduced annually within 25 y period ?

Post by celia »

Spgold wrote: Mon Jan 17, 2022 5:40 am The first year (end of 2022) 3% of the agreed total amount. Then each year there will be an annual increase of 2% in payments.
For example end of 2023 I will have to pay 3,06% , end of 2024 3,12% etc …

In other words the first year 3% payment of the agreed amount, which will compound by 2% each year until the end of the 25 year period when all capital is finally depleted.
First of all, I don't think this payment scheme will pay off the debt.

Image

In the first calculation column, the percent to payoff increases by 0.06% each year.
In the second calculation column, the previous year percentage is multiplied by 1.06% each year (compounding the previous annual 0.06% too).

Neither one gets to 100% payoff, as you can see. I had never heard of this type of payoff before, so I wanted to check it out. Maybe I don't understand the calculation.
My question is this :

How should I address this, since I do not want to “budget” this annual obligation and pay it off from every year’s income - especially because I have the full amount currently at my disposal and taking the long time horizon (25 years) into account ?
I would put the money in a separate account used for "partnership payoff".
If so, how should I invest this capital regarding AA ?
What **I** would do is leave 1/3 in cash and 2/3 invested just like my personal assets. The cash would cover you in case the stock markets decrease. The investments would give you growth so that you will get to keep the excess.

When making a payment, pull 1/3 of it from cash and 2/3 from investments.

I would also put the leaving partner's name down as beneficiary in case I die before this is paid off. The other partners should also make plans for making the payment(s) if they die. If the leaving partner dies first, her estate will still be owed the money. Of course, all of this must be in writing in case several of you die and someone not involved at this time needs to know what was agreed.
I would prefer to keep this case separate from all other investments, emergency funds, etc and rather look at is as a separate portfolio built for a specific reason …
I agree.
alex_686
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Re: How to invest funds that will be reduced annually within 25 y period ?

Post by alex_686 »

Spgold wrote: Wed Jan 19, 2022 5:38 am That sounds very interesting, although I do not quite understand how I could implement this especially the multiply factor…. What I do know for sure is that I have no access to zero coupon bonds.
First - what is your current funding level? i.e., what percentage of assets do you have divided by the Net Present Value (NPV) of your future liabilities?

The short answer is that nobody has access to zero coupon bonds. There is a gap between theory and practice. So you do the best you can do. When I was working in life insurance and had 25 year duration liabilities we used 10 year bonds, computer models, and actuaries. If you want to go into bond pricing theory you can create a portfolio that does a reasonable job of mimicking the zero coupon bonds that you need. Or you can just approximate it.

The long answer - well - it is too long. So, I am going to break it up into 2 parts.

Part 1: Let us look why you might want to do this by looking at a different portfolio construction technique, Liability Matching. With liability matching you buy zero-coupon bonds that match your future cash flow requirements. i.e., you buy 25 zero coupon bonds for the next 25 years.

There are other issues with liabilities matching.

First, lets ignore that you can't directly buy zero coupon bonds - we can leave that for part 3 if you want.

Second, you hint that you want to do liability matching by asking for a asset to offset the future payments. This is classic liability matching. However there is no asset that mimics this. You can mimic this with a bond portfolio.
Valuethinker wrote: Tue Jan 18, 2022 8:05 am So basically this is an inflation-indexed annuity?

It's certainly possible to buy fixed period annuities. However the charging and investment strategies can often be very opaque.

The main attraction of an annuity (Single Premium Income Annuity - SPIA to our American friends) is the longevity insurance embedded in it. Capping that eliminates the point of the product, to my mind.
Note - If you buy a annuity this is basically what they are doing. They run a bond portfolio using CPPI to ensure that you get your payments. There are nuances between running the portfolio yourself verse a insurance product verse a bond mutual fund. We can get into those issue if you like.

Third, why limit yourself to Italian bonds? I believe that the German Bund is considered to be the risk free choice right now.

Forth, the problem with liability matching is that it is very very conservative. The advantage it that it gives you a high certainty of being able to make the required payments. However, risk and return are linked. So low risk means low returns. I believe that the 10 year German Bund has a negative yield? The 30 year has a positive yield of a mere 0.3%?

Is there a way to extend the liability matching framework to included risky assets? Well, kind of. We can use CPPI. Part 2 will get into the math.
Former brokerage operations & mutual fund accountant. I hate risk, which is why I study and embrace it.
Topic Author
Spgold
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Re: How to invest funds that will be reduced annually within 25 y period ?

Post by Spgold »

celia wrote: Wed Jan 19, 2022 6:22 am
Spgold wrote: Mon Jan 17, 2022 5:40 am The first year (end of 2022) 3% of the agreed total amount. Then each year there will be an annual increase of 2% in payments.
For example end of 2023 I will have to pay 3,06% , end of 2024 3,12% etc …

In other words the first year 3% payment of the agreed amount, which will compound by 2% each year until the end of the 25 year period when all capital is finally depleted.
First of all, I don't think this payment scheme will pay off the debt.

Image

In the first calculation column, the percent to payoff increases by 0.06% each year.
In the second calculation column, the previous year percentage is multiplied by 1.06% each year (compounding the previous annual 0.06% too).

Neither one gets to 100% payoff, as you can see. I had never heard of this type of payoff before, so I wanted to check it out. Maybe I don't understand the calculation.
My question is this :

How should I address this, since I do not want to “budget” this annual obligation and pay it off from every year’s income - especially because I have the full amount currently at my disposal and taking the long time horizon (25 years) into account ?
I would put the money in a separate account used for "partnership payoff".
If so, how should I invest this capital regarding AA ?
What **I** would do is leave 1/3 in cash and 2/3 invested just like my personal assets. The cash would cover you in case the stock markets decrease. The investments would give you growth so that you will get to keep the excess.

When making a payment, pull 1/3 of it from cash and 2/3 from investments.

I would also put the leaving partner's name down as beneficiary in case I die before this is paid off. The other partners should also make plans for making the payment(s) if they die. If the leaving partner dies first, her estate will still be owed the money. Of course, all of this must be in writing in case several of you die and someone not involved at this time needs to know what was agreed.
I would prefer to keep this case separate from all other investments, emergency funds, etc and rather look at is as a separate portfolio built for a specific reason …
I agree.
Thank you very much for pointing this out. Actually the first payment is a little over 3% but for simplicity reasons I round it down to 3%, so in 25 time year period your second column does indeed come up to 100%.

In any case thank you for taking the time to do the calculations.
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Spgold
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Re: How to invest funds that will be reduced annually within 25 y period ?

Post by Spgold »

alex_686 wrote: Wed Jan 19, 2022 1:27 pm
Spgold wrote: Wed Jan 19, 2022 5:38 am That sounds very interesting, although I do not quite understand how I could implement this especially the multiply factor…. What I do know for sure is that I have no access to zero coupon bonds.
First - what is your current funding level? i.e., what percentage of assets do you have divided by the Net Present Value (NPV) of your future liabilities?

The short answer is that nobody has access to zero coupon bonds. There is a gap between theory and practice. So you do the best you can do. When I was working in life insurance and had 25 year duration liabilities we used 10 year bonds, computer models, and actuaries. If you want to go into bond pricing theory you can create a portfolio that does a reasonable job of mimicking the zero coupon bonds that you need. Or you can just approximate it.

The long answer - well - it is too long. So, I am going to break it up into 2 parts.

Part 1: Let us look why you might want to do this by looking at a different portfolio construction technique, Liability Matching. With liability matching you buy zero-coupon bonds that match your future cash flow requirements. i.e., you buy 25 zero coupon bonds for the next 25 years.

There are other issues with liabilities matching.

First, lets ignore that you can't directly buy zero coupon bonds - we can leave that for part 3 if you want.

Second, you hint that you want to do liability matching by asking for a asset to offset the future payments. This is classic liability matching. However there is no asset that mimics this. You can mimic this with a bond portfolio.
Valuethinker wrote: Tue Jan 18, 2022 8:05 am So basically this is an inflation-indexed annuity?

It's certainly possible to buy fixed period annuities. However the charging and investment strategies can often be very opaque.

The main attraction of an annuity (Single Premium Income Annuity - SPIA to our American friends) is the longevity insurance embedded in it. Capping that eliminates the point of the product, to my mind.
Note - If you buy a annuity this is basically what they are doing. They run a bond portfolio using CPPI to ensure that you get your payments. There are nuances between running the portfolio yourself verse a insurance product verse a bond mutual fund. We can get into those issue if you like.

Third, why limit yourself to Italian bonds? I believe that the German Bund is considered to be the risk free choice right now.

Forth, the problem with liability matching is that it is very very conservative. The advantage it that it gives you a high certainty of being able to make the required payments. However, risk and return are linked. So low risk means low returns. I believe that the 10 year German Bund has a negative yield? The 30 year has a positive yield of a mere 0.3%?

Is there a way to extend the liability matching framework to included risky assets? Well, kind of. We can use CPPI. Part 2 will get into the math.
Wow !!!

Thank you for the time spent to explain this and educate me.

I look forward to the 2nd part with much excitement…
Valuethinker
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Re: How to invest funds that will be reduced annually within 25 y period ?

Post by Valuethinker »

Spgold wrote: Thu Jan 20, 2022 1:04 am
alex_686 wrote: Wed Jan 19, 2022 1:27 pm
Spgold wrote: Wed Jan 19, 2022 5:38 am That sounds very interesting, although I do not quite understand how I could implement this especially the multiply factor…. What I do know for sure is that I have no access to zero coupon bonds.
First - what is your current funding level? i.e., what percentage of assets do you have divided by the Net Present Value (NPV) of your future liabilities?

The short answer is that nobody has access to zero coupon bonds. There is a gap between theory and practice. So you do the best you can do. When I was working in life insurance and had 25 year duration liabilities we used 10 year bonds, computer models, and actuaries. If you want to go into bond pricing theory you can create a portfolio that does a reasonable job of mimicking the zero coupon bonds that you need. Or you can just approximate it.

The long answer - well - it is too long. So, I am going to break it up into 2 parts.

Part 1: Let us look why you might want to do this by looking at a different portfolio construction technique, Liability Matching. With liability matching you buy zero-coupon bonds that match your future cash flow requirements. i.e., you buy 25 zero coupon bonds for the next 25 years.

There are other issues with liabilities matching.

First, lets ignore that you can't directly buy zero coupon bonds - we can leave that for part 3 if you want.

Second, you hint that you want to do liability matching by asking for a asset to offset the future payments. This is classic liability matching. However there is no asset that mimics this. You can mimic this with a bond portfolio.
Valuethinker wrote: Tue Jan 18, 2022 8:05 am So basically this is an inflation-indexed annuity?

It's certainly possible to buy fixed period annuities. However the charging and investment strategies can often be very opaque.

The main attraction of an annuity (Single Premium Income Annuity - SPIA to our American friends) is the longevity insurance embedded in it. Capping that eliminates the point of the product, to my mind.
Note - If you buy a annuity this is basically what they are doing. They run a bond portfolio using CPPI to ensure that you get your payments. There are nuances between running the portfolio yourself verse a insurance product verse a bond mutual fund. We can get into those issue if you like.

Third, why limit yourself to Italian bonds? I believe that the German Bund is considered to be the risk free choice right now.

Forth, the problem with liability matching is that it is very very conservative. The advantage it that it gives you a high certainty of being able to make the required payments. However, risk and return are linked. So low risk means low returns. I believe that the 10 year German Bund has a negative yield? The 30 year has a positive yield of a mere 0.3%?

Is there a way to extend the liability matching framework to included risky assets? Well, kind of. We can use CPPI. Part 2 will get into the math.
Wow !!!

Thank you for the time spent to explain this and educate me.

I look forward to the 2nd part with much excitement…
I would have to get into politics which is forbidden here. Who will lead Italy and how it will play out.

But I would be very cautious about tying myself solely to Italian govt debt.

The yield premium (spread) over German govt bonds tells you the market thinks there is risk. That risk could be existential for the Eurozone currency - if one of Europe's 4 largest economies had to suspend its Euro membership. But just the chaos that might arise from the wrong government saying or doing the wrong things...

And remember a very big part of the electorate in Germany is energised by 2 things: immigration & "no bailouts for spendthrift southerners". So there's pressure from up north as well as down south in Eurozone.

I've pushed Forum discussion limits by saying the above. Europe is in the depths of a very bad energy crisis, which is about to turn into a military "crisis" as well (it's only a crisis for the people who will get hit... but there will be refugees & knock-on effects). European industry cannot compete at current energy price levels, and will shut down causing more economic distress. The effect on the Eurozone's economy, plus the impact on consumer spending from higher heating and electricity bills, will be dramatic.

But there are long term issues in the Eurozone which remain unresolved (as for Great Britain, where I live - if you've ever seen Monty Python's "Life of Brian" then you will recognize the scene towards the end with the Judean Peoples' Liberation Front "Suicide Squad"). And Europe has the worst virus crisis in the world, arguably (in terms of disruption - WHO warnings). Plus demographics.

A wise investor diversifies as much as possible. Just owning Italian govt debt, more than the 45% or so it is of the Eurozone govt bond index, is not diversifying.

I have posted in other threads about my general recommendation for a global debt fund, hedged back into Euros. That diversifies credit risk but eliminates currency risk. Coupled with a globally diversified & unhedged equity portfolio, that gives a high level of diversification for a Eurozone investor.
alex_686
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Re: How to invest funds that will be reduced annually within 25 y period ?

Post by alex_686 »

So I lied. Math will be moved to part 3. Part 2 will be on your IPS and rebalancing. To start, the primary point of rebalancing is to manager your risk. This is more or less what this post is on.

You should select your Asset Allocation to best match your goals, risk tolerances, and market expectations.

Risk tolerances can be broken down in 3 parts. Willingness, or psychological ability to bear risk. This drives everything else. Need, as needed return to meet your goals. Lastly, "Ability" to take risks. Lets focus on this.

As your wealth grows so does you ability to take risk grows. The inverse is also true. As your wealth falls your ability to take risks falls. Your case is a clear example of this. You are trying to balance a asset against a liability. As your assets fall it is harder for those assets to pay off the liability.

Note, your willingness to take risk should also change. Some people are risk adverse. When they "hit their number" that means they have won the game and should take risk off of the table. Their willingness to take risk is inverse to their wealth and ability. So they will sell equities and buy bonds. Some people are risk seeking. Higher wealth means they can strive to hit their desired and stretch goals. Their willingness is in proportion to their wealth and ability. No right answer here but it is a critical point.

So as your wealth grows your risk tolerance should change should rebalance your assets. There are 2 main techniques of rebalancing.

The first are "Concave Strategies". This is what most people think about when talking about rebalancing strategies. The most popular rebalancing strategy is constant mix. The classic is 60 equity / 40 bonds. Or a permeant portfolio. As your wealth grows you sell equities and buy bonds. And vice-versa.

The second are "Convex Strategies" such as CPPI. As your wealth grows you shift more of your assets to risky equities. Critically, as your wealth decreases you shift more towards bonds. The point of this strategy is to ensure that it does not break through the lower protective floor.

2 big points.

First, neither strategy is dominate over the other. It is kind of like the game "rock, paper, scissors". In some situations one is better than the other, in others situations a different strategy will dominate. So think about this primarily about risk control.

Second, in the narrowly defined problem as given I think CPPi is the best strategy. You want to maximize upside growth while making sure you have sufficient assets to meet you loan payments. This is hinted at that you want a asset that mirrors the liability - and there is not one. However I expect that you have other goals than just to pay off this loan. To avoid the Cognitive Error of "Mental Accounting" you should step back and look at all of your goals, assets, etc. before picking a rebalancing strategy. i.e., write up a IPS.
Former brokerage operations & mutual fund accountant. I hate risk, which is why I study and embrace it.
alex_686
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Re: How to invest funds that will be reduced annually within 25 y period ?

Post by alex_686 »

Part 3: The Math

I am going to walk through a example. I am pulling numbers out of thin air. I am using the simplest version of CPPI. As I review this I have no idea if my numbers are supper aggressive or supper risk adverse.

1) Determine the NPV of the liability. Take all of the cashflows and discount the values by time using the relevant interest rate. For example, take your 10th year payment and look up what the interest rate for a 10 year bond is. For example, the 10 year German Bund is basically zero... Well, lets just simplify and call it 0% over the entire time frame. We live in odd times. Lets call it 100€.

2. Determine your assets. Let's assume 80€

3. Determine your floor. Let's assume 70€ or a 70% funding level. From a life insurance perspective you are required to have 100%. In pension land under 80% can be a yellow flag. The more aggressive you are the lower this number can be.

4. Lets randomly pick 4 for the multiplier. There are more sophisticated way of picking a multiplier.

5. Crunch numbers. 80€ - 70€ = 10€. 10€ * 4 = 40€. So 40€ in equities and 30€ in bonds.

5a. Crunch more numbers. Let's assume a 10% drop in equities, or a loss of 4€. Assets are now 76€. 76€ - 70€ = 6€. 6€ * 4 = 24€. So 24€ equities and 52€ in bonds.

I will let you work out what happens if equities go up.

Once again, the point of this rebalancing strategy is load up on as much risky equity while ensuring the portfolio never dips below the floor.
Former brokerage operations & mutual fund accountant. I hate risk, which is why I study and embrace it.
Topic Author
Spgold
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Re: How to invest funds that will be reduced annually within 25 y period ?

Post by Spgold »

alex_686 wrote: Thu Jan 20, 2022 10:29 am Part 3: The Math

I am going to walk through a example. I am pulling numbers out of thin air. I am using the simplest version of CPPI. As I review this I have no idea if my numbers are supper aggressive or supper risk adverse.

1) Determine the NPV of the liability. Take all of the cashflows and discount the values by time using the relevant interest rate. For example, take your 10th year payment and look up what the interest rate for a 10 year bond is. For example, the 10 year German Bund is basically zero... Well, lets just simplify and call it 0% over the entire time frame. We live in odd times. Lets call it 100€.

2. Determine your assets. Let's assume 80€

3. Determine your floor. Let's assume 70€ or a 70% funding level. From a life insurance perspective you are required to have 100%. In pension land under 80% can be a yellow flag. The more aggressive you are the lower this number can be.

4. Lets randomly pick 4 for the multiplier. There are more sophisticated way of picking a multiplier.

5. Crunch numbers. 80€ - 70€ = 10€. 10€ * 4 = 40€. So 40€ in equities and 30€ in bonds.

5a. Crunch more numbers. Let's assume a 10% drop in equities, or a loss of 4€. Assets are now 76€. 76€ - 70€ = 6€. 6€ * 4 = 24€. So 24€ equities and 52€ in bonds.

I will let you work out what happens if equities go up.

Once again, the point of this rebalancing strategy is load up on as much risky equity while ensuring the portfolio never dips below the floor.
I would truly like to thank you once again !

Just one question in your example.

Assuming I am starting with assets 80 and floor 70:as you suggested. What happens if we get a >25% drop in equities (instead of the 10% you mention) and I end up with Assets 68 ?

In this case I am below the floor. I know that >25% drop may sound too big, but that has happened in the past and though it bounced up fairly quickly there is no guarantee that this will happen again.

In other words how frequently should one check these Nr in order to make sure the floor does not get touched and in addition how frequently should one do all the necessary trades to constantly adjust the percentages ? Is it like the once in a year rebalance situation or something else ?
alex_686
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Re: How to invest funds that will be reduced annually within 25 y period ?

Post by alex_686 »

Spgold wrote: Fri Jan 21, 2022 1:10 am In this case I am below the floor. I know that >25% drop may sound too big, but that has happened in the past and though it bounced up fairly quickly there is no guarantee that this will happen again.

In other words how frequently should one check these Nr in order to make sure the floor does not get touched and in addition how frequently should one do all the necessary trades to constantly adjust the percentages ? Is it like the once in a year rebalance situation or something else ?
This is a good question. Like the use of zero coupon bonds it represents the difference between the world of idealized spreadsheets and the practicalities of the real world.

The short answer is that you rebalance your portfolio and update your IPS at least once a year.

The long answer is longer.

You can view your IPS as a ridge plan. Or you can view it as a logical intellectual framework created in times of calm rational thinking to guide your actions during times of chaos.

So lets think through how a 25% drop could play out. It could be like the dot.com crash where there is a hard drop in the market and a 8 year recovery. Or it could be like COVID, a hard drop and a fast snap back?

So, 2 things.

First, note that there is not a dominate rebalancing strategy.

Second, should you panic sell in a falling market?

From a professional view point I have to say yes. I work with a large portfolio in a highly risk adverse environment. If we fall below the floor the government regulators are going to come in and shut us down. We rebalance continuously - and to get to that level we have over a dozen people on my team. When the COVID crisis we panic sold because we could not bear to drop below the floor.

However, remember when I mentioned that a IPS is a intellectual framework? We did break through a couple of internal floors. Strictly speaking, according to our internal plan, we should have even sold more. We did not. The market was too wonky, the cost was too high.

From a personal view? I didn't rebalance. I could bear the risk. Calander rebalancing works well enough for me.

The correct answer is to back into the answer.

You are asking the correct questions.

What happens if there is a 25% drop in the market? What happens if my portfolio falls below the floor? How much time, money, and complexity do you want to devote to this?

You will have noticed that I got different answers for my professional and personal life.

So figure out where the red and yellow lines are, then calculate were the floor should be and what the multiplier is. It is actually more important to know why you formulated the rules then to follow the rules blindly.
Former brokerage operations & mutual fund accountant. I hate risk, which is why I study and embrace it.
Mors
Posts: 277
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Re: How to invest funds that will be reduced annually within 25 y period ?

Post by Mors »

I would address it as a "retirement scenario", which is basically investing mainly with a liability-matching objective and secondly for absolute return for a low rate of risk.
As a result, a conservative 30/70 or 40/60 stocks/bonds, with some part of the bonds being inflation-hedged, is an appropriate asset allocation.
As an alternative, or in addtion to the above, consider buying a SPIA (single payment immediate annuity) that covers the obligations as well. It is the best hedge but you wil sacrifice potential returns. In your case it is probable the best choice, since the payments are set in stone and there is no flexibility to reduce them in years with bad market returns or increase them in years with good ones.
In case you go with a SPIA, look for competitve offers from high quality insurance companies. You can also use more than one companies.
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