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Inker: Rethink the Retirement Glide Path

Kevin McDevitt, CFA

Kevin McDevitt: Hi, I'm Kevin McDevitt. I'm here at the Morningstar Investment Conference with Ben Inker from GMO.

Ben, thanks for joining us.

Ben Inker: Thanks for having me.

McDevitt: I want to ask you about the research you've done on saving for retirement, and in particular, the evaluation you did of the traditional fixed asset-allocation approach or the traditional glide-path approach. What are the potential drawbacks of those two asset-allocation methodologies?

Inker: I think the biggest concern we have about the traditional way putting together a glide path is it's assuming that you're always getting paid the same amount for taking risk. It's assuming that stocks are always at fair value and bonds are always at fair value.

And one thing that's pretty clear is valuations matter, and we think it's not reasonable to say, "I'm 25 years old; I can afford to take a lot of risk." That's fine. But if you're not getting paid for taking a risk, don't take it. And by the same token, even if you're a 75-year-old well into retirement, if bond yields are really low, and stocks are cheap, you should own some stocks.

I think the most important problem is that they don't respect the fact that valuations change, and as valuations change your portfolio should change, as well.

McDevitt: As an alternative, you've proposed the expected shortfall minimization framework. Why do you think this is a better option? And again, you kind of alluded to that with your last answer, but what are some of the advantages of that approach?

Inker: I think that's actually a slightly broader issue than the question of whether to be dynamic or not. The nice thing about expected shortfall is it's asking what is the question I'm trying to solve, and it's saying the problem I'm trying to solve is how do I avoid running out of money in retirement. And if you're putting together your portfolio with that in mind, we think you can get better outcomes. And among other things, what that says is there is no magic amount of equities you should own given your age. It's a combination of your age, how much money you have, how much money you need, and how much money you're getting paid for taking equity risk.

And so, we think with taking all of that into consideration, you can put together a better portfolio than simply assuming that your age is the only thing that should cause your weighting in equities to change.

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McDevitt: Now a lot of this is based, at least in terms of how you allocate assets, on your forecasted real returns for different asset classes. I think, it ties in with the expected shortfall framework. One aspect of this that might seem somewhat counterintuitive to people is let's say the real forecasted return for equities falls from let's 6.0% to 5.5%, but even if that's still better than they might get in other parts of the market, you recommend cutting equity exposure. Is part of the reasoning for this is that you feel like when the real forecasted return for equities falls, the tail risk is greater or the downside volatility is more of a threat than it otherwise would be?

Inker: It's a combination of two real factors. One of them is the risk of equities is always there, and if you're getting paid 7% a year for taking that risk versus 3% a year for taking that risk, in one case, the bad outcome is worse because you've got less cushion. If stocks are more expensive, you would expect them to do worse in bad economic times than when they start out cheap.

The other crucial view from our standpoint is if stocks are trading well above historical valuations today, probably, at some point in the future you're going to get a better opportunity. And one of the important things about thinking about a long-term problem like saving for retirement is you don't have to take the same amount of risk every day, every year. What you can do is say over the next 40 years, I'm going to have to take a certain amount of risk because I need a certain amount of return. But let me take more risk when I'm getting paid well for it, and let me take less risk when I am not getting compensated for the risk.

So what we would say is, yes, even if stocks are priced to deliver a higher return than bonds, if it's not as much higher as normal, own less in stocks.

McDevitt: Let's look at it from a behavioral standpoint. It makes sense, of course, that when you're getting paid for the risk, you want to take on that risk. But say if you are an investor who is at retirement age or even into retirement. From a behavioral standpoint how do you perhaps get them comfortable with this idea that I might actually take on more equity risk when I'm 65 or 70 years old.

Inker: This is one of the fascinating things where there's a wonderful opportunity associated with 401(k) and other retirement plans, but it's not clear who is going to step up and really take advantage of that opportunity. One of the nice things is most people in retirement plans don't move the money. They invest, it stays there.

And so whereas people who are allocating their assets on their own have a certain tendency to get scared at bad times and move out of equities when equities have just gone down and move out of bonds when bonds have just gone down, the nice thing is in these plans they don't tend to move.

So if the plan itself can do the right things, then you can take advantage of people's behavioral inertia. The question is how do you incent the plan sponsor to do the right things? And that's what we're really talking to plan sponsors about how to get them thinking about maximizing the probability of their employees having a successful retirement.

McDevitt: Ben, thanks for your time. We appreciate it.

Inker: Thank you.