Remember the rules of thumb [1] that advise shrinking your equity allocation as you age in retirement? Well, a radical paper [2] from two US retirement research experts, Wade Pfau and Michael Kitces, threatens to turn that advice on its head.
Their research suggests that investors may actually be better off increasing equity exposure during retirement.
In the world of retirement planning that’s like walking into the medieval Vatican and claiming that the Earth is not flat, that it does indeed revolve around the sun and, by the way Popey, women would make very good priests.
Sequence of returns risk
The conventional approach of decreasing your equity allocation in retirement is meant to protect you from big bear markets. The idea is to cut the risk of your portfolio evaporating when you have fewer years left and can’t wait for a market recovery.
But the biggest threat to a successful retirement is a long run of bad returns in the early years, otherwise known as sequence of returns risk [3].
A combination of a lost decade and having to sell equities at low prices in order to live can diminish your portfolio – to the point where it won’t recover even when the salad days return.
U-turn if you want to
The contrary approach being advocated by Pfau and Kitces builds in sequence of return risk protection, according to their results.
In this analysis, your equity allocation is trimmed in the run up to retirement as normal. But then, instead of continuing to cut shares out of your life like so many Mars Bars, you gradually increase your intake – post-retirement – for so long as ye shall last.
The authors call this a rising equity glide path and envisage a lifetime allocation to equities that resembles a U shape.
The range of outcomes once retired for the rising glide path boil down to two main eventualities:
Scenario #1: A poor stock market followed by an upturn
Part one: Bad stock market returns early on: The majority of your portfolio is in fixed income assets i.e. bonds, cash and/or annuities [4]. You don’t permanently damage your portfolio because your living expenses are mostly paid from the fixed income, so you don’t have to sell equities at low prices.
Part two: Stock market returns recover later: Equities should eventually bounce back due to mean reversion [5]. Because your equity allocation is increasing, you benefit from pound-cost averaging [6] – buying low and selling higher. These gains carry you to safety, making up for the ground lost in the early years. (By contrast, a strategy that requires you to sell equities at this time chokes off the upside, increasing the chances of you running out of money.)
Scenario #2: A good stock market followed by a bad one
Part one: Good stock market returns early on: Your portfolio grows well beyond the amount you need [7] for a happy retirement. At this point you could decide to protect your winnings and move into less risky assets [8], knowing your retirement is secure (unless you marry a Kardashian).
Part two: Poor returns later: In most scenarios the portfolio swelled so much in the golden years that it’s still able to sustain your life style as your clock runs down, even if (/when) the market eventually turns lower.
Of course, other things could happen, too.
- The market could be great for decades: If the market smiles upon your entire retirement then who cares how rich you are when you die? (My postal address is available on request, and I currently accept bequests…)
- The market could be bad and stay bad: If your fate is nothing but lost decades then we’re all in trouble. At least your early (and traditional) heavy fixed income allocation starts you off on the right foot.
[9]
So what should I do?
You can find out how all the scenarios play out in detail by reading the research paper [2] and Kitces’ excellent précis [10].
To give you a flavour, they researchers find that the chances of not running out of money at a 4% withdrawal rate are optimised when:
- Equity allocation at the start of retirement is 20 – 40%.
- Equity allocation at the end of 30 years is 60 – 80%.
The percentages change according to each scenario’s assumptions based on differing withdrawal rates, returns, retirement lengths and objectives. The historical returns scenario favours an initial equity allocation of 30% and a final figure of 70%.
The authors suggest that the rising equity glidepath can be managed using a rule like rebalancing [11] 1% of your portfolio per year from fixed income to equity.
The more downbeat the return assumptions1 [12], the less difference a rising equity glidepath makes in comparison to conventional strategies.
In certain low-return scenarios, the results require investors to think about what they fear most – missing their target income goal, or missing it by miles.
If you’re dead set on reaching an ideal income goal then you need a high equity start and end point. Essentially you’re gambling that equity returns turn out favourably, but you could suffer if they don’t.
If you choose a low equity start and end, then you limit the chances of a big shortfall but increase the probability that you will run out of money before the end of your retirement. (In other words, you’re not heavily exposed to a major fail scenario for equities that means you burn through your capital very quickly, but by the same token you’re not exposed to a major success scenario either).
Tricky.
Why can’t it be simple?
It seems the debate on the best retirement strategy is far from over.
When I first started investing, I clung on to rules of thumb as beacons of certainty that I could navigate by. But it’s obvious now that there is no single rule of thumb that everyone can abide by and expect to live happily after.
Certainly simpler strategies [13] exist, and rules of thumb can help us manoeuvre into the right areas, but it is in our nature to want to optimise our approach.
Rising lifespans [14] throw another Zimmer frame into the traditional machinery of pension planning, too.
Pfau and Kitces acknowledge there is plenty more work to be done refining their analysis. Other researchers may well counter or improve upon their findings.
But what makes this research so exciting is its potential to cave in the calcified assumptions of old while helping us achieve better results just when we need them – in the future.
Take it steady,
The Accumulator
- The study uses historical returns as well as a more conservative set designed to mimic the possibility of the ‘new normal.’ [↩ [19]]