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.
Financial-planning expert Michael Kitces and American College professor Wade Pfau published a paper last year on the appropriate default equity glide path for retiree portfolios. They found that rising stock allocations during retirement have the potential to actually reduce the probability of failure and the magnitude of failure in a portfolio. Morningstar recently spoke with Kitces about his and Pfau's findings.
Question: Michael, you co-authored a paper with professor Wade Pfau where you looked at what equity allocations should look like in retirement. 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 something retirees should consider.
Michael 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, but it's just doing it in a manner that works a little bit better.
We see a natural retiree bias toward that anyway. 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 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. He found that decreasing equity exposure through your retirement hurts; you got lower income and withdrawal rates. It wasn't 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.
Wade and I took it one step further and asked, "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 up with a portfolio that we would have held throughout anyway. So, if I were going to be [allocated to 60% stocks and 40% bonds] in retirement, we're never going to go higher than 60%. But rather than being 60% in 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.
Q: Why does it work? Let's talk about the benefit of why that would actually help lead to better outcomes.
Kitces: To sort of overgeneralize, there are four ways that your retirement can go.
1) Scenario number one is, everything is just wonderful and everything goes up throughout your retirement, in which it basically 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. That's like if I started retirement in 1982, and portfolio values increase throughout retirement.
2) Then we get to scenario two, which maybe is closest to the Japan scenario, in which everything just goes down forever. It goes down for 30 years. You try to wait out a bear market, and the market never comes back. Thirty 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 go through waves. You get a good period; then you get a bad period. And if we look at it that way, basically there are two ways this can go. Scenario three: We can get a horrible period at the start, and then it recovers later. Or scenario four: We can get a great period at the start, and then it's horrible later.
3) 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 '60s heading into the '70s, the '70s were not as painful.
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 up 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 into stocks.
If we started, say, 30% in equities, and we increased that 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%-15% of equities into your portfolio, buying them at cheaper and cheaper prices. 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.
4) The other way that we can go is "the good, then bad" scenario. This is like the mid-1980s retiree. 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. Now here we are 14 years later, and we're just finally making new highs on the Dow and the S&P 500 from where we were in 2000. So it was a wonderful first half of your retirement, but a 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 occurring. If something bad happens when I'm my 60s, maybe I can go back and get some part-time work and 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. Whatever trajectory I'm on, that's pretty much how I'm going to live it out.
What we find, however, and this is kind of sequencing 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 affects your legacy but not your actual retirement-income sustainability from where you started at the beginning.
We 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 bit 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 of 2000 would be really scary. We're only talking about things like gliding from 30% to 60%. You're still diversified; you can navigate this poor market, especially because, frankly, your time horizon is not huge at that point because you've already gone 15 or 20 years into your retirement.
Q: Let's talk about this from a practical standpoint. You've touched on this that we're not going crazy with equities; we're not going to an 80%-90% stock allocation. 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 advance in retirement. What do you say when you marry this research with some of these practical considerations about what makes people feel comfortable?
Kitces: We're trying to figure out 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 find that's the starting point. Certainly, if you weren't comfortable owning more than 60% equities now, I really don't want to glide you higher than 60% at some point in the future; that 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.
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+.