November 4, 2015
November 4, 2015
Featured in Worth Magazine, August – September 2015 Issue
Helping make financial resources last over a lifetime is one of the most important services BOS provides its clients. As such, we wanted to share our perspective on some of the key considerations that help ensure the availability of those resources throughout a client’s later years.
We start with a review of some recent research that challenges the traditional approach to asset allocation that equity assets should be reduced as a person ages. We conclude that there is no right mechanical formula for asset allocation in retirement – instead, asset allocation strategy should be based on several key considerations..
Recent academic research1 suggests that a strategy of starting retirement with a relatively low equity allocation and gradually increasing the equity allocation during retirement increases the probability of success (defined as not running out of money in retirement). This “rising equity glide path” approach is counter to the traditional concept that equity exposure should decrease with age (as one has fewer years to recover any losses). The premise of the rising equity glide path is that retirees are at greatest risk of a big stock market downturn early in retirement and retirees can benefit from reducing this risk at the start of retirement while increasing it later.
We’ve reviewed this research carefully and concluded that these two approaches, the rising equity glide path and the declining equity approach, generate similar success rates assuming both approaches have the same average equity allocation over the retirement period. The table below displays a sample of results from one of the recent studies2. The rising equity glide path strategy (starting retirement at 30% equity and ending at 50% equity) and the declining equity strategy (starting retirement at 50% equity and ending at 30% equity) generate success rates that are nearly identical. Moreover, a third strategy of simply maintaining a 40% equity allocation throughout retirement generates a success rate similar to the other two strategies.
The same study also looked at the magnitude of potential shortfalls in the worst 5% of scenarios. Here too, for the three strategies listed in the table, the results were similar.
The rising equity glide path approach also faces some practical limitations. Investors with predominantly taxable accounts would likely have to sell stocks and realize capital gains in order to start retirement at a lower equity level. An increasing equity strategy may also be very difficult to implement, especially if the market declines significantly when equity levels are due to rise (think 2008).
Given that no particular asset allocation strategy (rising equities, fixed equities, or declining equities) provides a noticeably higher success rate, how else might retirees seek to ensure that they do not outlive their assets?
Portfolio risk level at retirement: Making sure the portfolio risk level is not too high at the point of retirement is more important than the trajectory of the equity allocation thereafter. A fundamental portfolio design premise is to take on only as much risk as is needed to achieve overall retirement goals. The goal here is to reduce the likelihood of the retiree reacting emotionally and dramatically reducing their equity allocation after a big market decline, an action that could severely impact the portfolio’s long-term sustainability. This approach focuses largely on risk tolerance which is unique to each person.
Withdrawal rate and flexibility: The withdrawal rate also has a significant impact on whether a portfolio will be sustainable – lower withdrawal rates increase the success rate. Similarly, having flexibility to adjust spending if portfolio returns are low increases the likelihood the portfolio will not be depleted.
Here are some other factors to think about when considering asset allocation in retirement:
How much annuity income does the retiree have from sources such as Social Security or a defined benefit pension?
How much cushion is there in the portfolio to cover spending needs including potentially large health care or long-term care expenses?
How much of a legacy does the retiree wish to leave to heirs or charity?
How should the retiree balance withdrawals from tax deferred (IRA/401(k)), tax exempt (Roth IRA) and taxable (Trust) accounts to minimize taxes?
At BOS we continue to work closely with clients in designing portfolio strategies that maximize their opportunity to meet their retirement goals. Asset allocation is an essential component of this equation.
1 Pfau, Wade D., and Michael E. Kitces. “Reducing Retirement Risk with a Rising Equity Glide Path.” Journal of Financial Planning 27 (1): 38–45; Delorme, Luke. 2015. “Confirming the Value of Rising Equity Glide Paths: Evidence from a Utility Model.” Journal of Financial Planning 28 (5) 46–52.
2 Pfau, Wade D., and Michael E. Kitces. “Reducing Retirement Risk with a Rising Equity Glide Path.” Journal of Financial Planning 27 (1): 38–45, Table 2
3 Assumes annual withdrawals of 4% of the balance at retirement, increased annually at the rate of inflation. Based on 10,000 Monte Carlo simulations. Success rate defined as the percent of scenarios in which retiree does not run out of money over a retirement period of 30 years.