Mon, 31 Mar 2014
Retirees who start with a conservative equity stake and build that up to a target percentage over the years will experience less volatility while still achieving solid returns, 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. Should equity allocations trend up during retirement? Joining me to discuss that topic is financial-planning expert, Michael Kitces.
Michael, thank you so much for being here.
Michael Kitces: Great to be back.
Benz: You have done some research. You co-authored a paper with professor Wade Pfau where you looked at what equity allocations should look like in retirement. And you research came up with a somewhat counterintuitive finding, where you actually suggested that equities should trend up as someone goes further in retirement. Let's talk about your general findings and why you think that this is maybe something that retirees should look at?
Kitces: Certainly the reactions to some of the research that we've done have been interesting at the suggestion that maybe equities should actually glide upward and you would get a little bit more aggressive through retirement.
One of the key things to note about that coming right out of the gate, though, is equities would be gliding upward through retirement, starting from a much more conservative point. While a lot of the discussions around this have been framed as "How aggressive is it to be adding equities for people through retirement?"--what we were actually finding is that this is a strategy to give you lower equities in retirement, lower average equity exposure overall, just doing it in a manner that works a little bit better.
We see a natural retiree bias toward that anyways. We don't really want to own any more equities than we have to. [They can be] a little volatile and a little scary. And we've had this kind of rule of thumb for a very long time of "Own your age in bonds," or 100 minus your age in stocks," all of which gets you the same point. As you're getting older your equity exposure declines and that was a way to own fewer equities through retirement.
The problem is that particular approach where you decrease them over time, psychologically I think there is some comfort to it. Unfortunately from the research, it just doesn't work very well. [Financial expert] Bill Bengen did some work on this back in the late 1990s after he had done his initial safe withdrawal-rate research and found that decreasing equity exposure through your retirement hurts; you got lower income and withdrawal rates. Not a huge difference if you only did a little bit of trimming, but you got lower outcomes.
David Blanchett here at Morningstar now did a wonderful study on this six or seven years ago where I think he tested something like 43 different versions of decreasing equities--so you decrease by little a year or a lot every year, or a little bit than more and then more and then a little bit, like all the different ways that we could glide that equity exposure down. And basically what he found was just sticking with the same balanced portfolio and rebalancing to it was working better than all of these decreasing equity exposure approaches.
What Wade and I did was really just kind of take it one step further and ask "If starting [with higher equity allocations] and coming down doesn't work very well and starting [at one level of allocation] and sticking [with that same level of allocation over time] goes better, what would happen if we started lower and glide it back up to where we were going to be in the first place?" So we'll own less in equities early on and will maybe end out with a portfolio that we would have held throughout anyways. So, if I was going to be 60%-40%d in retirement, we're never going to go higher than 60%, but rather than being 60% equities every year, what if we went down to 30% in equities and then started gliding back up toward that original 60% target. And what we found was it actually works.
Benz: Why does it work? Let's talk about the benefit of why that would actually help lead to better outcomes.
Kitces: So why it works? To sort of overgeneralize, there are four ways that your retirement can go. Scenario number one is, everything is just wonderful and everything goes up throughout your retirement in which case basically it doesn't matter what you do. All of it's going to work, and it's just a matter of how much money is left over at the end.
Benz: That's the 1982 retiree.
Kitces: Right. That's like if I started in '82 and things go up forever.
Then we get to scenario two, which maybe is closest to the Japan scenario. So everything just goes down forever. It goes down for 30 years, you try to wait out a bear market and it never comes back, 30 years later, you're still off 70%.
When we go through scenarios like that, frankly, there's not a lot we can necessarily do to help. At some point things are just so horrific for so long, you're going to end up needing to cut your spending a bit.
Now, in the middle, we get what frankly looks like the history of the U.S. and most markets around the world, which is we kind of go through waves. You get a good period, then you get a bad period, and if we look at it that way, basically there's two ways this can go. We can get a horrible period at the start and then it recovers later, or you can get a great period in the start and then it's horrible later.
So, a bad start/good finish would be something like a late 1960s retiree. You kick off your retirement, you go through the '73-'74 bear market, inflation goes to double-digits, you have the worst bond bear market, and at the same time you're having this horrible stock bear market. You get no appreciation in your stocks for the first 10 or 15 years. If you are not bankrupt by the early '80s, you enjoy the greatest bull market of the century, but you have to spend conservatively enough in order to get there.
In those scenarios, we find these rising equity glide paths work incredibly well, for the relatively simple reason that if you had just owned less in stocks in the late 60's heading into the 1970s, the '70s were not as painful.
Benz: So it's that sequencing risk that you and a lot of other researchers are talking about?
Kitces: Right. Just literally, you're taking some of the sequencing risk off the table by owning less exposure to stocks. Then ironically it helps even though you own bonds, which also had a bear market and lost money as rates rose through the 1970s, but because you still lose less money in a bond bear market than you lose in a stock bear market, you still ended out better even with the bond bear market by having the portfolio tilt a little bit more toward bonds. But you dollar-cost average your way back in the stocks. If we started say 30% equities and we increased you by 1% a year, if you started in the late 1960s, by the time you get into the early 1980s you have dollar-cost averaged another 10% to 15% of equities into your portfolio buying them at cheaper and cheaper prices.
So, you absorb less of the pain of the '70s because you just owned less in stocks. But you've still averaged your way back in so you will own more in equities by the time you get back to the 1980s and the good returns show up.
In that "bad in the first half, good in the second half" scenario, we find the rising equity glide paths really help, and frankly, that's the most crucial scenario. Those are the failure scenarios and the ones that we have some ability to do something about it.
The other way that we can go is sort of "the good, then bad" scenario. So this is kind of like the mid-1980s retiree, so you're a little ways into the bull market and you decide you are ready to retire. Retirement is wonderful for the first 15 years. Then you get to 2000, and now here we are 14 years later and we're just finally making new highs on the Dow and the S&P from where we were in 2000; so wonderful first half of your retirement, miserable second half of your retirement.
Now ironically, as we talked to a lot of retirees, that's the one they're actually afraid of. If something bad happens in my 60s, like maybe I can go back and get some part-time work, maybe I can adjust. I more often find clients in practice who are most afraid of what happens in their 80s because it's the point of no return. "I am not going back to work at that point, like whatever trajectory I'm on, that's pretty much how I'm going to live it out."
Well, what we find, though, and this is kind of sequence risk in reverse, if you really get a scenario where things are that good in the first half of your retirement, it basically doesn't matter how bad the second half of the retirement is. If you're taking a modest withdrawal rate all along, you can't fail in the second half. You could diminish how much money you're going to pass on to your kids; it impacts your legacy but not your actual retirement-income sustainability from where you started at the beginning.
We kind of get this--I jokingly labeled it--"heads you win, tails you don't lose" outcome. So, if we get "the bad, then good" scenario, the rising equity glide path helps. We own fewer stocks in the bad years; we dollar-cost average into the good years. If we get "the good, then bad sequence," basically all that happens is we own a little but less of wonderful-return stocks along the way and we leave a little bit less money to our kids, but we're still not in danger of having a retirement problem.
Again, it's not like we're going up to a 100% in equities where the tech crash would be really scary; we're only talking about things like gliding from 30% to 60%. You're still diversified, you can navigate this, especially since, frankly, your time horizon is not huge at that point, because you've already gone 15 or 20 years into your retirement.
Benz: So, let's talk about this from a practical standpoint. I think you've kind of touched on this that we're not going crazy with equities, we're not going to 80%, 90%.
But risk preferences are in the mix. A lot of retirees are probably uncomfortable with this idea that they will take higher equity positions as they go further on in retirement. What do you say when you sort of marry this research with some of these practical considerations about what makes people feel comfortable?
Kitces: Well, we're trying to figure out maybe what our equity exposure will glide back to. Our starting point is, take whatever portfolio you would be comfortable owning right now. If you would be willing to own 70% equities, great; if it's only 60%, OK; if it's only 50%, fine. Whatever that number is that you would own now, that's all you're ever going to glide back to. At no point will we ever actually own more in equities than what you were already ready to own today; we're just going to spend most of your retirement owning less than that. It's literally a more conservative strategy with less average equity exposure throughout your retirement.
We kind of find that's the starting point. I mean, certainly, if you weren't comfortable owning more than 60% equities now, I really don't want to glide to you higher than 60% at some point in the future. This is kind of asking for a problem. But what we found pretty clearly was if you were already comfortable owning 60% [in stocks], gliding from 30% to 60% works better than just owning 60% throughout. Not dramatically, but it definitely helped, and you can just sleep a little better at night that you are riding less equity volatility for most of the years.
Benz: Michael, lots of moving parts here. I think we could talk about withdrawal-rate strategies all day, but thank you so much for sharing these insights. We really appreciate you being here.
Kitces: My pleasure.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.