It is easy to pick on conventional wisdom or poke fun at “rules of dumb,” but sometimes doing so is a worthy exercise. Who better than Wade Pfau and Michael Kitces to take a closer look at how wise mainstream thought might be.
Since Bill Bengen’s 4 percent safe withdrawal rate paper, and particularly over the last decade, financial planners have been flooded with studies exploring the subject of withdrawal rates and portfolio sustainability. The conventional wisdom, which lines up with our intuition, is that as we enter and advance through the retirement phase of life, we should reduce the risk level in a portfolio and own less equities than we would during the accumulation phase of life. As we get older, it seems natural that we would be more risk averse.
Monte Carlo simulations can give us some idea of the likelihood that a certain portfolio structure and spending pattern will be sustainable. One thing virtually all withdrawal rate studies show clearly, with or without MCS, is that avoiding stocks entirely through retirement is not likely to produce an acceptable spending level for a long period of time. Therefore, most retirees will own some stocks in their portfolios.
The disaster that most new retirees and their advisors seem to fear is that the stock market tanks shortly after retiring, but a meandering market can be even worse. Starting retirement in 1929, suffering a colossal collapse in equity markets, and slogging through years of economic depression isn’t actually the worst-case scenario. The 1966 retiree faired slightly worse due to rapidly increasing costs and a market that did not advance during the early years of retirement.
Simulations show bad markets early in retirement are the leading cause of failed trials. The sequence of returns matters a great deal for portfolios experiencing regular withdrawals.
To mitigate the risk of adverse markets early in retirement, most choose to find a balance between stocks and more stable holdings such as bonds and cash. Having a significant allocation to bonds and cash not only reduces the downside of the portfolio as a whole, it provides a source of cash that prevents retirees from being forced to liquidate equities in order to meet cash-flow needs for many years.
This can help avoid selling stocks during market declines, provides time for the market to recover, and it can be a useful behavioral management tool in that it provides clients a reason not to panic during a downturn. If they don’t feel they have to sell, perhaps they won’t. Historically, bad markets are followed by good markets.
Many versions of the so-called bucket approach also benefit from this behavioral element. In a market downturn, if the client can see that the short-term and intermediate-term buckets are stable sources of cash, they’re more likely to allow long-term assets to stay invested for the long term.
Kitces and Pfau noticed that one effect of spending the shorter-term buckets first was that the equity portion of the portfolio tended to rise as the fixed portion was spent down. The allocation to stocks was going up during retirement, not down. They wondered what might happen if a rising equity allocation was put in place by design. Their newest research paper examines that question. A write up will appear early in 2014 in the Journal of Financial Planning, but you can read Kitces’ description on his blog, Nerd’s Eye View; see Pfau’s take at Wade Pfau’s Retirement Researcher Blog, or the actual draft here. Table references are from the actual draft.
Using historical returns of various asset allocations over a 30-year retirement and a constant 4 percent real withdrawal rate approach, they found that the probability of success is higher than a steady allocation to stocks if the portfolio is established conservatively and adjusted annually to increase the allocation to stocks.
For instance, keeping a portfolio with a 60-40 allocation between stocks and bonds resulted in a 93 percent success rate. However starting the portfolio at 30 percent equities and increasing the allocation to stocks 1 percent each year of those 30 years resulted in a 95 percent success rate. Similar patterns resulted from most balanced portfolio mixes. (Table 6)
The authors also looked at the number of years that the 4 percent spending pattern was sustained. These figures give us one angle on the magnitude of the failure rather than just the frequency.
Ninety-five percent of the simulations using a constant 60 percent equity allocation lasted more than 27.7 years, but the 30 percent to 60 percent glidepath lasted the full 30 years, says Nerd’s Eye View. Kitces and Pfau also ran simulations using reduced-return expectations to reflect the popular notion that equity and bond returns would be below historic averages going forward. This, too, resulted in about a 2½-year increase in the life of the portfolio at a 95 percent confidence level.
Increasing equity exposure may seem counterintuitive at first blush, but the more one considers the issue, the more sense it makes. If a retiree starts off with good markets this is all mute, of course, because they should be fine.
By reducing risk at the beginning of the retirement, less damage is done in a bad market and the more time is provided to benefit from market recovery. Further, the longer the market struggles, the more stocks are bought at the relatively lower valuations and the better the performance when markets advance. In essence, increasing equity exposure over time during an early retirement phase marred by poor market conditions can bear some mathematic similarity to dollar-cost averaging.
As the authors put it, it’s a matter of heads you win, tails you don’t lose.
Clearly, having elderly clients who are aggressively weighted in equities can be problematic, so what are planners supposed to do with this information? I think there are a few takeaways.
First and foremost, stocks will need to remain a significant portion of the portfolios of most retirees. With interest rates low, it is not particularly difficult to convey this message.
Second, it should still be considered unwise to be 100 percent out of equities or 100 percent in equities. A range of “balanced” portfolios is likely to remain a prudent choice. Combinations that started with 20 percent to 40 percent equities and finished the 30-year period between 60 percent and 80 percent seem to provide similar results on the frequency and magnitude of failure. The portfolio values at the end of 30 years were predictably much more varied.
Third, if a rising equity glidepath has a positive dollar-cost averaging-like effect, it seems logical that a declining glidepath would have a negative reverse dollar-cost averaging effect. Indeed, many of the results show the rising equity glidepath beats the constant allocation method, which beats reducing equity exposure gradually as a client ages. Most media coverage I have seen about the study give the impression that the rising glidepath is clearly superior. I disagree.
Reducing the equity allocation over time does not appear to be as damaging as one might assume from the perspective of frequency and magnitude of failure. Starting at 60 percent and reducing to 30 percent produces an identical historical success rate as sticking with 60 percent equities throughout retirement. At the fifth percentile for the number of years supported, the declining path actually adds 1/10 of a year based on the historic record (Nerd’s Eye View).
Fourth, I’m not ready to implement a rising glidepath because the data presents important contradictions to ponder. For instance, the best worst-case shortfall in the “Lower Future Returns” and 4 percent withdrawal rate scenario (Table 4) resulted from gliding from 20 percent to 70 percent equities; however, the success rate applicable to that approach was only 54 percent. All but one combination of starting and ending allocations that began with at least 50 percent equities, whether rising or declining from there, had higher success rates. Even a constant 40 percent allocation succeeded 58 percent of the time.
From a success rate perspective, the rising equity glidepath was consistently inferior to a constant allocation in many scenarios using lower than historical returns or a higher (5 percent) initial withdrawal rate. (Tables 3,4,and 5)
By my reading, the study does not make the case that a rising equity glidepath will produce a dramatically better result. It does suggest some improvement appears possible, particularly for conservative spending patterns.
Finally, pay attention to the work of these two gentlemen because it is clear that they are doing studies with financial planners in mind and not just for the academic exercise. As the authors point out, they are modeled a gradual increase in equities expressly because they believe implementing in this way could be more palatable in the real world than a more sudden shift to equities.
I’m looking forward to the additional research they allude to, such as examining different schedules of changing allocations, viewing the issue over a full lifetime of accumulation and decumulation, and assessing a valuation overlay.
Dan Moisand, CFP, has been featured as one of the America’s top independent financial advisors by Financial Planning, Financial Advisor, Investment Advisor, Investment News, Journal of Financial Planning, Accounting Today, Research, Wealth Manager, and Worth magazines. He practices in Melbourne, Fla. You can reach him at [email protected]