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Do Retirees Have It Backward?

The argument for owning more stocks with age.

John Rekenthaler, 12/04/2013

A Radical Idea
This Monday, the fund-industry publication Ignites drew my attention to a paper called "Reducing Retirement Risk with a Rising Equity Glide-Path." The authors, Wade Pfau and Michael Kitces (the latter is an occasional Morningstar.com contributor), advocate just what the title suggests, that retirees would be best off increasing their equity allocation over time. To use the nomenclature of target-date funds, they should adopt a rising glide path.  

My immediate thought was Dow 36,000Sell the stock market gospel into a hot market by telling the audience what it wishes to hear. But such is not the case. Neither author has a history of publishing crowd-pleasers. Rather, the two typically write detailed and relatively arcane articles about financial planning, such as variable income withdrawal rates, the use of intermediate annuities during retirement, or how financial advisors should be regulated. Fast-talking marketers they are not.

 To state upfront: The paper doesn't successfully make its case. That will be clear later in this column, when I post the numbers. However, it is a useful exercise that offers instructive points. Thanks to the authors for providing six pages' worth of excellent tables! 

The intuition for a rising glide path is straightforward. Retirees who own a mix of stocks and bonds are safe if stocks perform reasonably well throughout the retirement period. They also are in good shape if stocks thrive during the early years of retirement, but then slide in the later years. The big bulge afforded by the early bull market plumps up the portfolio so that it can withstand the lean that follows. The primary danger to retirees, then, comes from an early bear market--when stocks are whacked shortly after the investor retires. 

In which case, argue the authors, retirees are best off raising their stock allocation. The immediate market decline shrinks the size of the initial nest egg, so that annual income withdrawals become a higher percentage of the principal. The portfolio needs market appreciation to nurse it back to health. The more stocks, the likelier it is that health will be recovered. (This principle holds true if stock returns are fully independent--meaning that a series of losses improve the chances of upcoming gains--but the effect is even stronger if stocks are mean-reverting, which historically has been the case.)

The authors test the thesis under only high withdrawal rates--4% per year (expressed as a percentage of the initial wealth, adjusted each year by the amount of inflation) and 5%. Even the lower of the two is an aggressive target given today's stock and bond valuations.*

*Yes, I know, I have argued that 4% is a reasonable rate. But that argument assumes a flexible withdrawal strategy, rather than the fixed and immutable 4% per year that is used in this paper's model.  

The paper shows simulation results for these two withdrawal rates for three capital-market expectations: 1) the historical data from 1926-2011; 2) an estimate from financial planner Harold Evensky that slashes expected stock returns by 300 basis points per year and bonds by 80 basis points; and 3) an even-more conservative forecast that cuts stock returns slightly further and takes bonds' real returns to nothing. 

is vice president of research for Morningstar.

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