For the past 20 years—due to the growing research on safe withdrawal rates, the adoption of Monte Carlo analysis (a method of considering many simulations), and just a difficult period of market returns—there has been an increasing awareness of the importance and impact of market volatility on a retiree’s portfolio.
Dubbed “sequence of return” risk, retirees are cautioned that they must either spend conservatively, buy guarantees (e.g., annuities), or otherwise manage their investments to help mitigate the danger of a sharp downturn in the early years.
One popular way to manage the concern of sequence risk is through so-called “bucket strategies” that break parts of the portfolio into pools of money to handle specific goals or time horizons. For instance, a pool of cash might cover spending for the next three years, an account full of bonds could handle the subsequent five-to-seven years, and equities would only be needed for spending more than a decade away. This “ensures” that no withdrawals will need to occur from the equity allocation if there is an early market decline.
Yet the reality is that strict implementation of such a cash/bonds/equities bucket liquidation strategy is more than just an exercise in mental accounting; it can actually distort the portfolio’s asset allocation and lead to an increasing amount of equity exposure over time. This occurs as fixed-income assets are spent down while equities continue to grow. Recent research shows that despite the contrary nature of the strategy—allowing equity exposure to increase during retirement when conventional wisdom suggests it should decline as a retiree ages—it turns out that a “rising equity glide path” (where the path of equity exposure ‘glides’ higher year after year) actually does improve retirement outcomes. If market returns are bad in the early years, a rising equity glide path ensures that retirees will dollar cost average into markets at cheaper and cheaper valuations. Conversely, if the markets are good, retirees won’t have a lot to worry about in retirement anyway (except, perhaps, how much excess money will be left over at the end of their life).
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