Note: This video is part of Morningstar's October 2014 5 Keys to Retirement Investing special report.
Christine Benz: Hi, I'm Christine Benz for Morningstar.com. It's often taken as an article of faith that retirees' equity allocations should decline as the years go by. But some recent research has taken a closer look at that issue. Joining me to discuss his research into this topic is David Blanchett. He is head of retirement research for Morningstar Investment Management.
David, thank you so much for being here.
David Blanchett: Thanks for having me.
Benz: David, I think a lot of retirees think about what their portfolios might look like over the years and think, "Well, the equity weighting should take up less and less of the portfolio as the years go by." That has kind of been the standard way of doing things. What's the underpinning of that logic of putting together portfolios in that way?
Blanchett: There are lots of reasons why people think that equity risk should change over time. A key perspective for academics is this idea of human capital, where you have human capital--it's a very bond-like asset. As you age, you deplete that bond-like asset; so, you replace that with bonds in your portfolio.
Another perspective is a thing like time diversification, where if you have a long period of time until you need the money, you can be more aggressive. As you approach the need, you should become more conservative. So, there are lots of reasons and there are great rules of thumb out there. I think the most common--"100 minus your age"--is a great starting point for how risky you should be in your portfolio.
Benz: There was some recent research that came out. Michael Kitces and Wade Pfau took a look at this glide path issue. Their conclusion was actually the opposite of what many retirees have been doing--that maybe equity allocation should start out pretty light in retirement and then get heavier. What was the thinking and what were the general conclusions from that research?
Blanchett: So, there are actually lots of pieces of research that you can use to answer this question. They have been coming out for probably 20 or 30 years, and the conclusions vary. Everyone uses different models. What Michael and Wade found was that, for a lot of folks, an increasing glide path makes the most sense, which just means that you should look to possibly have more risk in your portfolio over time. So, for example, as opposed to being 45% stocks on average for your retirement, you start at, say, 30% stock and you increase to, say, 60% if you can afford to do so.
Benz: I know one of things that they concluded was that retirees need to be on guard against this sequencing risk--the idea of hitting that bad market early on in retirement. Why would that be such a bad thing?
Blanchett: A retirement portfolio has to last 20 or 30 or 40 years, and so what you don't want to have is a bad initial negative return. But sequence risk today is actually really interesting because today there is risk in buying bonds. If you buy a bond with a negative yield after inflation, you're kind of capturing this zero percent rate of return that is well below long-term averages. So, if you don't really consider what yields are right now or how risky bonds are today, I think you might underestimate how risky it is to buy bonds today for retirees.
Benz: So, you've been working in this glide path space for a while. But recent research that you did looked at a variety of different glide paths: the traditional one (the one that slopes down in terms of equities), static, and so forth. Let's talk about the variables you use to test those various glide paths.
Blanchett: I actually wrote a paper on glide path construction for retirees back in 2007, and what I found back then was that a constant glide path is actually quite efficient compared with a decreasing glide path. So, a decreasing glide path is one where you start with, say, 40% stocks and you go to 10% stocks by the time you are 95 years old. And this paper actually tested eight different shapes--an increasing glide path, a decreasing glide path, a V-shaped, an inverse V-shaped. And then they decline at different levels or increase at different levels, and I compare those to a constant glide path.
I use a little bit more complex model. I actually test over 6,000 different possible scenarios. I say, "Okay, what happens if returns are higher than average or inflation is lower than average?" All of these different things. And a long story short, what I find is that based upon your unique scenario, there can be lots of different glide paths that work for you. So, in some instances, an [increasing glide path] seems best; in some instances, decreasing seems best; in some instances, the constant glide path is best. But overall, I found that the decreasing glide path--the tried-and-true method--was the best glide path for most retirees.
Benz: And you found that the increasing equity glide path was actually among the least efficient.
Blanchett: That's right. I think for about 10% of scenarios it was the best. So, there are situations where it makes sense to have an increasing glide path--based upon returns, unique preferences, etc. But by and large, it was also the least efficient. So, in about three fourths of all simulations, it was the least efficient glide path. What was the most efficient glide path was a decreasing glide path--one that becomes more conservative as you move through retirement. And this is really consistent with, I think, people's perspectives on what you should do when it comes to risk through time.
Benz: And you also noted that your research didn't even incorporate any sort of risk preferences into supporting that declining equity glide path.
Blanchett: It's almost impossible to model all of the unique preferences of individuals. So, most models--mine included--focus on more of an outcomes measure. How well does this portfolio do in terms of providing income during retirement? And what I do ignore in this model is your preference for risk. How does your risk preference change over time? And most retirees want to be more conservative as they age.
I sometimes say that equity risk is like broccoli. I should eat more broccoli because it's good for me, but I don't like taking a risk on my portfolio. So, for investors, I think that the idea of an increasing glide path may makes sense mathematically or academically, but it may not be very palatable from a risk perspective. So, I think these findings that actually decreasing glide paths are best are consistent with not only risk preferences but also the overall best approach toward building portfolios.
Benz: David, such an important topic. Thank you so much for being here.
Blanchett: Thanks for having me.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.
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