Late last year, two well-respected financial-planning researchers, Michael Kitces and Wade Pfau, dropped a bombshell on the retirement planning community. Their paper, "Reducing Retirement Risk with a Rising Equity Glide-Path," suggested that the conventional strategy of reducing a portfolio's risk later in life (by gradually lowering the portion invested in stocks in the years leading up to and through retirement) is not the best approach.
(In this article, the term "glide path" refers to the change in one's stock allocation approaching and in retirement. Traditionally, the stock allocation is reduced in order to lower risk. This is a declining glide path. Increasing one's stock allocation, as suggested in the new research, would be a rising glide path.)
Rather, they presented evidence that a "U-shaped glide path" — in which investors delay reducing their stock holdings to their lowest levels until the years immediately surrounding their retirement date, and then gradually increase them throughout retirement — leads to better outcomes.
The rationale for this is straightforward. Understandably, most stock/bond retirement portfolios will fare well if stocks have strong performance throughout a person's retirement years. Outcomes will also likely be favorable if stocks perform well early in retirement then fall later (because the early gains are able to build the portfolio up enough to withstand the future losses). The primary danger to most retirement portfolios is when a bear market hits early in retirement. In that situation, large stock-market losses in combination with the withdrawals for living expenses can put a sizeable dent in the portfolio, and it can be difficult to recover.
The authors, therefore, advocate trimming a portfolio's stock allocation to 20%-40% by retirement age, then gradually building it back up, normally by increasing the stock allocation by 1% or so a year (perhaps faster if a major bear market occurs early on). Taking into account a number of factors — different ranges of possible returns, different allocations between stocks and bonds, and various withdrawal rates — their research indicated this rising glide path approach consistently caused portfolios to last a year or two longer than a traditional portfolio with declining stock allocations.
Not everyone agrees
Any time the accepted orthodoxy is challenged, it's likely to produce a reaction. This is true even in the relatively placid world of retirement planning. One business professor tweeted in response, "Sure. Why not? Let's allocate 90-year-old grandma to 90% stocks."
A more substantive rebuttal came from John Rekenthaler, Vice President of Research for Morningstar, who wrote two columns in response to the new idea. While he believes the new idea has merit, his analysis indicates that the appeal of the U-shaped glide path varies depending on how aggressively a portfolio is weighted to stocks. For example, let's assume Tom approached retirement with a stock allocation of 60% and planned to gradually reduce it to 30% over time. And Mike did the opposite — approached retirement with a stock allocation of only 30% and built it over time to 60%. In those scenarios, Mike, using the non-traditional U-shaped glide path would likely do better.
However, if their starting and ending points were lower — say 40% for Tom instead of 60% and 10% for Mike rather than 30% — the traditional approach used by Tom is more appealing. Higher average stock allocations seem to benefit more from the new approach, whereas lower average stock exposure seems to do better with the traditional approach.
Rekenthaler also found that the higher the assumed withdrawal rate, the better the traditional declining stock allocation strategy looks by comparison.
What does it mean?
Perhaps the most surprising thing that emerges from examining this new research and the response to it is this: given how drastically different these approaches are (starting with a high stock allocation and gradually reducing it vs. starting with a low stock allocation and increasing it), we would expect the outcomes to differ much more significantly. Instead, in most of the scenarios, the differences are relatively small. For example, given a particular set of return and withdrawal assumptions, a rising glide path might show a 95% chance of success, while the traditional declining path might be 90%. In many scenarios, the gap was only a single percentage points or two.
This is rather shocking when you consider how opposite these allocation approaches are. As Rekenthaler summarized: "Thus, varying the asset allocation by up to 50 percentage points, along with changing the shape of the glide path, meant the difference between failure and success in only one out of 20 simulations. I would not have guessed." Neither would we.
This reinforces three beliefs SMI has long held about investing generally, and retirement investing specifically:
- Your budget matters a lot more than your investing prowess. If such huge changes in investing approach make such relatively small differences to the typical outcomes, it suggests to us that a much more important factor to retirement success is having a firm grip on your spending habits. Knowing what you spend and controlling it is going to greatly impact your results, whichever approach you choose.
- A flexible withdrawal strategy is key. The fatal flaw in all of these analyses is that they use a fixed withdrawal rate of either 4% or 5% of the initial portfolio balance, adjusted for inflation. While that may be a good way to compare scenarios in a research setting, it's a terrible way to handle your real-world withdrawals.
Building some flexibility into your withdrawal strategy to respond to events (such as a severe stock-market decline) will go a long way in making sure you don't run out of money in retirement. In fact, something as simple as making withdrawals of a certain percentage of your current portfolio balance at the beginning of each year, rather than a percentage of your beginning balance, can significantly extend the life of your retirement accounts. The only time your beginning portfolio balance is relevant is on "day one" of retirement. After that, you need to be flexible. You adjusted your spending based on changes in your income throughout your career. Why would you not adjust your spending in response to changes in the size of your portfolio throughout retirement?
There's no single "right" answer as to how to structure your retirement portfolio. Given that you can get similar — and satisfactory — outcomes from such widely varying approaches as we're discussing in this article, the crucial point seems to be that you find and follow an approach that you can actually stick with. Starting with a high stock allocation and reducing it gradually seems to work. Starting with a low stock allocation and increasing it gradually seems to work.
You know what probably won't work? Starting with a high stock allocation, then lowering it dramatically near the bottom of the first bear market you encounter, only to hold that low stock allocation through most of the next bull market...well, you get the idea. This is where SMI's risk temperament analysis comes into play, as well as the variety of strategies we offer that cater to different risk appetites. Remember, the goal isn't to get as rich as possible, but to provide for your needs throughout retirement. Sometimes the pursuit of the former ends up undermining the latter.
At an institutional level, which would include the increasingly popular "target date" retirement-fund universe, there appears to be serious room for further examination and study along the lines of what Kitces and Pfau are suggesting. If such an approach really does produce superior outcomes under a broad range of assumptions, that's something these managed products need to consider.
Less clear is the application to the individual investor. We're not saying their idea doesn't have merit for individuals, just that it's more difficult to apply. Psychologically, the idea of increasing stock exposure as age increases (and typically, risk appetite decreases) is a tough sell, even if it makes sense intellectually.
Given that behavioral aspect and the newness of this research, we're not inclined to change SMI's approach to retirement investing or allocations. From what we've seen, any improvement in results from doing so would likely be modest at best. But this is a development that we view with interest, and we hope it leads to further analysis along the lines of what Mr. Rekenthaler at Morningstar has done. We'll continue to follow the research and keep you posted.