Sat, 21 Mar 2015
Ratcheting down your equity exposure when stocks are richly valued can help combat 'sequence of return' risk and improve retirement-income sustainability, says financial-planning expert Michael Kitces.
Michael Kitces is a partner and the director of research for Pinnacle Advisory Group, and publisher of the financial planning industry blog Nerd's Eye View. You can follow him on Twitter at @MichaelKitces or connect with him on Google+.
Christine Benz: Hi, I'm Christine Benz for Morningstar.com. The connection between market valuations and retiree asset allocations has been a hot topic among retirement researchers. Joining me to discuss his research in this area is financial-planning expert Michael Kitces.
Michael, thank you so much for being here.
Michael Kitces: Great to be here today.
Benz: Michael, one of the big focuses in your work and some work you've done with some co-researchers has been on the idea of how market valuations should affect retiree glide paths--or what their asset allocations looks like--as well as retiree withdrawal rates. Let's talk about the role of valuation in setting glide paths as well as in potentially affecting withdrawal rates.
Kitces: So, the context for all of this is the phenomenon of what's broadly been dubbed sequence-of-return risk. That's the idea that once you're taking distributions out of a portfolio, it's not enough that your returns add up to what you're expecting in the long run. If you get a long sequence of bad returns upfront, followed by a long sequence of really good returns at the end, and you're taking distributions along the way, you can literally run out of money during the bad stretch. Your long-term return will be exactly what you thought, but unfortunately, it all comes with good returns in the second half when your account balance is zero, and you get no benefit from this.
So, that leads us in the direction of a couple of different paths for how we manage this sequence-of-return risk. One approach is I can be a little bit more flexible around my spending. I can take my spending cuts when times are bad; I can make it up later. And the other is that we try to actually manage our asset allocation, or what's often called the glide path--how that asset allocation changes over time--to try to manage this.
Now, the problem is the traditional rule of thumb out there, which is often called the "declining equity" glide path--where I start with higher equities when I'm young, and they wind down each year as I age all the way through until I die. That gives us rules of thumb such as "own your age in bonds" or "100 minus your age in stocks."
While that actually works reasonably well for an accumulator--it means you start tamping down your risk as you get close to retirement--it creates some problems if you actually keep doing that through retirement. And the issue goes right back to the sequence scenario. So, if I get a situation where I retire in 2000, I've got a relatively high equity exposure, and I take the full brunt of the market decline. Then, after the market decline has occurred, I start doing my glide path, which means I start taking equity exposure off the table. Then, [the stock market] recovers a bit, and then I get another decline in 2008. Now, I'm taking even more equity exposure off the table. And so if you were following that plan, by the time you get to what's been a pretty amazing bull market over the past five or six years, you actually would have taken a huge chunk of your equities off the table already. So, you would have borne all the pain upfront, but now that we're getting a six-year market rally, you would have taken a lot of your equity exposure off the table, and you would actually be falling further and further behind in retirement.
[I did a study last year] with Wade Pfau, who is the professor of retirement income at American College; what Wade and I looked at is what happens if you actually flip this around. Instead of being more aggressive earlier in retirement and taking it down over time, you actually start a little more conservative in retirement and allow your equity exposure to drift up over time. We called this the "rising equity" glide path.
And what we found is that you actually get a very modest improvement in your retirement outcomes--despite the fact that you actually end up taking a little bit less risk overall--because when your pot of money is the biggest, which is right at the beginning of retirement, you are generally taking the least equity risk. And that's part of why it works.
So, if we think of it in broad terms, my retirement can go one of two ways. I can get terrible returns at the beginning and good ones at the end, in which case this helps. I'm conservative during the bad returns, and then I get more aggressive later as the good return show up. Or I get the other sequence where the returns are really good at the beginning and really bad at the end, in which case you actually end up getting so far ahead if you get a great bull market at the beginning of your retirement that it doesn't actually matter that you get a little bit more aggressive later. You are still going to have a large account balance left over. You might add a little bit of volatility at the end, but you're still going to have less [volatility] than maybe where you would have started and you're going to be dealing with a lot more wealth than you ever expected in the first place. So, it kind of creates this heads-you-win, tails-you-don't-lose scenario. If you get the bad sequence, it helps you; and if you get the good sequence, in essence, you end up leaving a slightly less large huge inheritance.
Benz: One question is if you take this research and you look at where we are today and look at the fact that while equity valuations aren't particularly cheap, bonds certainly don't appear to be cheap, cash is yielding nothing. So, what should, say, people who are in their early 60s trying to figure out their retirement do? Do you think that adopting this more conservative glide path makes particular sense right now, given that the risk of some sort of a lousy sequence of returns appears likely?
Kitces: We do. [There is another piece of] research that Wade and I did, which we've actually just released out to the Journal of Financial Planning. The challenge is that we can see there is a subset of scenarios where you get an especially bad market sequence, and these rising equity glide paths help. The caveat is that, most of the time, your retirement is not a catastrophe the day that you retire. Maybe you get a little bit of volatility and things are bumpy, but most of the time for most retirees, [your retirement is not going to have] the worst possible timing of the century and have bad things happen--which means that, most the time, these kinds of more conservative rising equity glide path strategies aren't actually necessarily.
So, Wade and I dug in a little bit further and tried to figure out whether there is any way that you can predict when these are more or less necessary, and what we found is that it's actually driven very heavily by what market valuation looks like, because the greatest drawdown or risk in your retirement portfolio is a horrible bear market. We can get bond bear markets, but equity bear markets are worse. So, if we start with where the equity bear markets occur and where they occur the worst, there is no doubt they are more likely to occur in higher-valuation environments. It's not universal that high valuations always leads to disasters, but the disasters are disproportionately more likely to occur when you are at high valuations.
So, what we found, in essence, is that these more conservative strategies tend to work better when you are in higher-valuation environments, which unfortunately I guess is where we find ourselves today. So, we did a lot of this with what's called cyclically adjusted P/E ratios, or Shiller CAPE, or P/E 10. When you use those measures, what you find is that we are at a relatively high valuation in today's environment. We're not quite as high as we've been at the worst in the past, but we are elevated and we are certainly elevated into the danger zone.
Now, the second extension that we did off this research: What we were basically finding was if valuation was reasonable, you could own more in equities at the beginning of retirement or, frankly, you could just own a 60-40 portfolio, rebalance throughout, and things would be pretty good. If you were at a relatively high-valuation environment, the rising equity glide paths work better.
What that really meant was--and this isn't exactly rocket science--if equities are more expensive, you probably want to start your retirement a little conservative. And if equities are cheap, you can start your retirement a little bit more aggressive. What we found because of that is you can actually replicate much of these rising equity glide path strategies and benefits by literally just taking your asset allocation and bumping it up or down a little bit for your valuation.
So, if you imagine that your normal portfolio would be 50-50 stocks and bonds, you might start at 50-50 and if we are in a high-valuation environment like this, you just take your equity exposure down 10% or 15%. If you are in a really cheap-valuation environment at some point down the road, you might take it back to your neutral 50% or you might even dial it up to 60% or 65%. And what we actually found is that those adjustments of just 10% or 15% in equity exposure are not huge adjustments, but they actually do give you a material improvement in your withdrawal rates and your retirement-income sustainability.
It's not the best timing mechanism because long-term valuation is not a very good short-term timing indicator. But for planning through a long-term 30-year retirement, we found it actually still helps at the end of the day. You get maybe a modest improvement in returns, although only over a very long time period; but you do the really important part, which is you dampen down the volatility when equities are most expensive.
And the driving force that we really found to all of this is that--notwithstanding the fact it's not terribly exciting to dial down your equity exposure, which means dialing up your bond exposure when bonds are not giving the most appealing yields and cash is giving even less--that equity risk still becomes the driver. It's the double-edged sword. The equity growth is the crucial thing that lets us keep up with inflation, particularly if inflation picks up, but the equity downside is really the huge risk.
So, if we have to choose for a retirement portfolio [whether you] want to be exposed to a bond bear market or a stock bear market, the answer is you definitely want to pick the bond bear market over the stock bear market. And if you want to manage your concern around the potential for rising rates and losing money in bonds, you simply get a little bit shorter in your duration--you own shorter-term bonds. It gives you a little bit less of a yield in the near term; but if you are expecting rates to go up, you are expecting you are going to be able to reinvest that higher down the road without taking the bond-price losses in the meantime.
Benz: So, this idea of making fairly modest adjustments, taking the equity exposure down when stocks look expensive, that also helps address one thing I was worrying about, which is behavioral forces. I know that a lot of these valuation indicators sometimes are early in terms of sounding the alarm bells--
Kitces: They can be very early. It's really not a good short-term-timing indicator.
Benz: So, you're not taking your equity exposure way, way down; you are still able to participate in the upswings, maybe just not to the same extent.
Kitces: Right. And that's kind of the acknowledgement to it. And frankly, I think the best example of it are scenarios like the mid- to late 1990s. Even by 1996, by things including Shiller CAPE, markets were getting expensive. That was when Irrational Exuberance came out. We said, "Markets are really expensive here. This really seems dangerous and elevated."
Ten to 15 years later, this was correct. You run forward returns from 1996 over 10 or 15 years and your equities took a huge excess volatility over bonds and were not producing any material improvement in returns. So, it was right over 10 to 15 years. Of course, in the subsequent three years, the markets went up another 50% to 75%. So, you have to be really cautious. It's not an effective short-term-timing indicator, which is one of the reasons why we looked at doing this with relatively modest adjustments.
I had actually done a study in the Journal of Financial Planning with some co-authors a couple of years ago where we actually found that even doing things where you go all in or all out based on these market valuations technically works. You do get a modest improvement in long-term returns, but only at the psychological cost of massive differences between your return and what the market is doing in the short term. This includes the possibility that you might have gotten out of the market in '96 and just bought bonds and you would have been very happy 10 years later, but you would have been so horrifically miserable for the next three years while you failed to participate in the market. I think the more moderate adjustments are material enough to have a benefit and, frankly, they are not so huge that it becomes difficult to stay the course through the strategy.
Benz: Michael, such an important topic. It's always great to hear your insights.
Kitces: My pleasure, absolutely.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.
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