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By Christine Benz | 03-12-2014 11:00 AM

Why Adding to Stocks in Retirement Is a Good Idea

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 your 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 to 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, Morningstar's head of retirement research, did a wonderful study on this six or seven years ago where 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 and then more, or more and then a little bit--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 worked 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 were going to be 60%-40% 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.

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