Using Asset Allocation Funds in Distribution Portfolios

Dec 3, 2020 / By Craig L. Israelsen, PhD
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Asset allocation funds are attractive to retirees who need to protect money as they begin withdrawing from their retirement funds. But a look at historic performance gives a warning on how to strategically implement these unusual funds.

Asset allocation funds are convenient, abundant—and different. There are over 1,300 such funds as of 10/31/2020 with a total of $1.22 trillion in assets. Funds that are categorized as “asset allocation” have a material commitment to more than one asset class.

The largest 15 asset allocation funds are shown below in Table 1 (only one share class per fund was allowed, which ruled out several different share classes of American Funds Balanced and American Funds Income Fund of America). These 15 giants have a combined total of $417 billion in assets, or 34% of the overall asset total.

Since January 1, 2000 the best performer (assuming a lump sum investment) among the biggest 15 asset allocation funds was T. Rowe Price Capital Appreciation (PRWCX). Over the 20.8 years from 1/1/2000 to 10/31/2020 it produced an average annualized return of 10.36%. The next closest was FPA Crescent at 8.70%.

On average, these 15 asset allocation funds have roughly 62% allocated to stocks (as of 10/31/20). The classic “60/40” ratio is clearly evident. The far right column in Table 1 shows how well these 15 asset allocation funds have grown money over the past nearly 21 years—again, based on a lump sum investment. Importantly, however, these funds are also attractive to retirees who need to protect money in their distribution portfolios. Thus, we need to evaluate their performance when money is being systematically withdrawn.

Table 1: 15 Largest Asset Allocation Funds

Source: Craig Israelsen
*Data as of October 31, 2020
**Only one share class per fund was allowed into the analysis

Accordingly, we turn our attention to the information in Table 2. Here we see the performance of each fund when subjected to annual withdrawals. Two time frames were analyzed: (1) the 20.8-year period from January 1, 2000 to October 31, 2020, and the (2) 10.8-year period starting on January 1, 2010 to October 31, 2020.

The assumed starting balance in the retirement portfolio was $1,000,000 for both time frames. The first year withdrawal (at the end of the year) was $50,000—representing a 5% withdraw rate. The subsequent annual withdrawals (at the end of each year) were inflated by 3%. Thus, over the 20.8 year period, the total of the 21 withdrawals was $1.43 million. Over the 10.8 year period the total withdrawal was $640,390. Taxes and inflation were not considered.

The differences in the ending account balances among these 15 funds over the full 20.8 year period are staggering (columns with blue heading). T. Rowe Price Capital Appreciation finished with a balance of over $3.9 million whereas Vanguard LifeStrategy Growth had a negative ending balance of -$36,824, meaning it ran out of money before the end of the 20.8 year period. What could have caused such a difference in the ending outcomes?

One of the keys is shown in the next column to the right of the ending balances: the return of each fund during the first three years of the withdrawal period. PRWCX had a return of 10.64% from 1/1/2000–12/31/2002, whereas VASGX lost 10.15% over the same three years. Simple message: You must get out of the gate safely during the first three to five years after starting withdrawals from a retirement portfolio. It’s also worth noting that 10 of the 15 funds finished the 20.8 year period with more money than they started with—even after having withdrawn $1.43 million. Quite remarkable. A reminder that retirement portfolios can actually grow over time.

Table 2: Performance of 15 Funds When Subject to Annual Withdrawals

Source: Craig Israelsen
1Retirement portfolio starting balance was $1,000,000 on January 1, 2000. First year withdrawal was $50,000 at the end of the year. Subsequent end-of-year withdrawals increased by 3%. Total amount withdrawn over the 20.8 year period was $1.43 million.
2Retirement portfolio starting balance was $1,000,000 on January 1, 2010. First year withdrawal was $50,000 at the end of the year. Subsequent end-of-year withdrawals increased by 3%. Total amount withdrawn over the 10.8 year period was $640,390.

The second time period analyzed (10.8 years from 1/1/2010–12/31/2020) shows a very different—and encouraging—picture (green highlighted column headings).

All of the funds finished with more than the starting balance. PRWCX was once again the dominant performer, but there were no meltdowns among the 15 funds. Why?

As before, the key is the performance in the first several years after withdrawals begin. The “poorest” return during the three-year period from 1/1/2010–12/31/2012 was 7.29% (VSCGX). Interestingly, Vanguard LifeStrategy Conservative Growth had a slightly higher ending balance than Franklin Income even though FKINX had a better starting three-year return of 9.69%. FKINX had losses in 2015, 2018 and so far in 2020, whereas VSCGX had only a fractional loss in 2015, a small loss in 2018, and has a positive YTD return in 2020 (as of October 31). While the performance in the first three to five years is important, the size and sequence of subsequent returns is also highly relevant in the ending outcome of a retirement portfolio.

It is important to remember that published performance data assumes a lump-sum investment, which obscures the impact of sequence of returns. Retirement portfolios are highly sensitive to the sequence of returns that they experience. Thus, as this article demonstrates, we have to do our own analysis of funds that we are considering using in retirement portfolios. Using published lump-sum returns is not adequate when evaluating funds that will experience withdrawals, such as a retirement portfolio.

This brings us to the main message: If we had perfect knowledge on January 1, 2000, we would have certainly chosen T. Rowe Price Capital Appreciation among these 15 funds. But we didn’t have it then…and we don’t have it now. Thus, if you use asset allocation funds as building blocks for clients who are retired, it makes sense to use several funds—not just one. As demonstrated in Table 2, the size and sequence of returns among the various asset allocation funds leads to markedly different outcomes. Don’t bet the farm on only one of them.

Diversify among your diversified asset allocation funds.

Craig L. Israelsen, PhD, is an Executive-in-Residence in the Personal Financial Planning program in the Woodbury School of Business at Utah Valley University. He is the developer of the 7Twelve® Portfolio. Learn more at www.7TwelvePortfolio.com.

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