A 2014 study conducted by Michael Kitces, the head of planning strategy at Buckingham Wealth Partners and publisher of the Nerd’s Eye View blog, and Wade Pfau, professor of retirement income at the American College, showed some benefit to increasing equity allocations through retirement. For instance, at a 4% initial withdrawal rate, holding on to a portfolio with a 60/40 allocation to stocks and bonds through retirement resulted in a 93% success rate. An even better success rate of 95% could be achieved, however, by starting the portfolio at 30% equities and increasing that allocation by a percentage point annually until it reached 60% after 30 years.
Similar patterns resulted from most balanced portfolio mixes. Unfortunately, Kitces and Pfau’s research also noted that a rising equity glide path was consistently inferior to a static allocation in many scenarios that used lower-than-historical returns or a higher initial withdrawal rate (of 5%).
Steady Rebalancing
Withdrawal studies typically use a portfolio rebalancing strategy based on the calendar. I see three conflicts with this assumption. One is academic, one is practical and one is behavioral.
The academic objection arises from the studies suggesting that rebalancing quarterly, semiannually or annually is not optimal. It’s more effective to set the rebalancing around tolerance bands guided by the funds’ original weightings (according to the work of researchers Gobind Daryanani of iRebal TD Ameritrade and Marlena Lee of Dimensional Fund Advisors).
In practice, it makes little sense to incur the costs associated with rebalancing simply for the sake of trading on a certain date. This is especially true for taxable accounts, where the tax costs can be quite high, especially over time, as assets tend to appreciate. As a result, many practitioners employ a tolerance band methodology or use their judgment to override the calendar’s prompt.
The behavioral problem is that when markets sink, many clients will balk at rebalancing because that means buying more stock. In their minds, they are buying more of the very thing that is causing them stress. Mathematically, this can be a problem because a portfolio that is not rebalanced will tend to not recover as fully as a rebalanced portfolio once markets turn up. If clients don’t rebalance in a disciplined way, their odds of success decrease.
Longevity
Most of your clients will not need money for 30 years. Most life expectancy tables show that for a married couple, both of whom are 65 years old, there’s a probability of almost 20% that one will live 30 years. Of course, traditional financial planning clients are not average. They are generally of above-average means and educated, both factors highly correlated to above-average life spans.
Mortality tables used in pricing annuity products provide some insight. The people purchasing the contracts must be confident they will live an extended life, and the insurance companies depend on this confidence and adjust for adverse selection. Most of these tables tag the probability of one of the 65-year-old spouses surviving to age 95 at near 40%.
Almost every client I have ever worked with cited a long, healthy life span as an explicit goal. It is a bit unnatural to plan to "fail" on that account, but failure is the likely result for most clients.
We are rightly concerned about clients spending too much and running out of money in their lifetimes, but there is a price to pay for being too conservative, too. For retirees, that price is a retirement doing less than they could have. The more conservative they are about their assumptions, the greater the odds that they will be giving their heirs the ability to do more financially because they did less. That might be the approach they want, but they should choose it based on good information, not statistics that make something good (a long life) sound like something bad.
Using Safe Withdrawal Studies Wisely
The flaws in these assumptions do not render the studies useless. Far from it. The body of work around the subject gives us a framework for discussion and planning. I have found that by explaining the basic framework, results and flaws in the assumptions in these studies that clients can more easily understand the choices they have now and the ones they will likely face. What causes problems? How will we spot them? When do those problems warrant a change? What changes should be made?
Not much can be guaranteed in life other than that it’s full of changes. If you know one might happen and what can be done when it does, a change can be far less scary. Rather than relying on predictions, rely on the ongoing and dynamic process of financial planning.
Dan Moisand, CFP, practices in Melbourne, Fla. You can reach him at [email protected].