Reduce Stock Exposure in Retirement, or Gradually Increase It?
by Michael Kitces and Wade Pfau
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).
Of course, the challenge to utilizing a rising equity glide path strategy as a retiree is that many would obviously be concerned about having more equity exposure during their later retirement years. Yet the research shows rising glide paths can be so effective that exposure to stocks can start much lower to begin with—so low, in fact, that the strategy may actually lead to lower average equity exposure throughout retirement, even while obtaining more favorable outcomes. And ironically, it turns out that for those who do want to utilize a rising equity glide path, the best approach might actually be to implement it as a bucket strategy in the first place, where cash and bonds are spent down over time and equities are allowed to run (higher) for a period of years.
Sequence Risk, Bucketing, and Retirement Success
In the 1990s, William Bengen published his first research on safe withdrawal rates. He made the fundamental point that it doesn’t matter what a retiree’s average returns are to determine if their plan will be successful; instead, it’s necessary to look at the sequence in which those returns occur, as there are numerous historical scenarios where the long-term average may have been healthy, but the sequence meant retirees had to withdraw far less. After all, it doesn’t really matter if returns average out in the long run, if ongoing retirement withdrawals plus bad market returns early on mean there’s no money left when the good returns finally arrive.
Accordingly, the conclusion of the safe withdrawal rate research was that retirees should set their spending targets based not on average returns, but on the worst-case scenarios that have occurred in history1. Spending rates are presumed to be “safe” if they are low enough to survive all of those scenarios (whether due to below-average returns throughout retirement, or reasonable returns but an unfavorable sequence).
Of course, in practice, retirees often notice the importance of return sequencing the moment a bear market occurs as they’ve begun down the retirement path. They see their account balance fall precipitously and begin to worry—sometimes excessively so—about whether they need to adjust their spending or change their portfolio (or both). Accordingly, some retirees have adopted various forms of “bucket” strategies over the years, designed to help them get comfortable with their ongoing volatility. For instance, if there’s a “bucket” with three years of cash, retirees may worry less about a short-term market decline. If there’s a second pool of money with intermediate bonds for the subsequent few years, such that equities don’t have to be touched for eight to 10+ years in total, retirees may be further soothed. If the bulk of ongoing expenses can be covered from direct cash flow sources (e.g., Social Security payments, a pension, annuitized income, etc.), it may be even easier to tolerate the market volatility.
However, the reality is that many of these types of bucket liquidation strategies often are more than just an exercise in mental accounting acrobatics; having alternative fixed-income sources to tap in the early years can help, both mentally and financially, to mitigate the danger of sequence risk. After all, the mathematical reality is that if there are no cash flows (i.e., there are no necessary withdrawals) then return sequencing is no longer an issue. In other words, as long as the retiree truly doesn’t have to take any withdrawals from equities in the early years and can allow time for any early retirement bear markets to recover, the primary sequence risk of the portfolio/retirement scenario can be avoided.
Impact of Rising Equity Glide Paths on Retirement Income
While bucket approaches—from just holding cash reserves, to “time-segmenting” pools of money for use over time, to partially annuitizing to reduce income needs in the early years—can be effective at reducing sequence risk, the reality is that such strategies disproportionately spend from fixed-income assets and let equities grow. As a result, bucket approaches will end up, after a number of years, with “distorted” asset allocations: A shrinking fixed-income allocation and a rising percentage of equities. Of course, such outcomes can be averted by systematically replenishing the cash and fixed-income buckets, but separate research has shown that approach can actually result in less retirement income2. The retiree simply ends up dragging too much into cash/low-yield investments as those asset classes are constantly replenished over time. In fact, as it turns out, the best outcomes are the ones where the short-term buckets are used to mitigate sequence risk in the early years, but are not replenished. For instance, if the fixed-income assets are used to partially annuitize the portfolio, with the remainder predominantly or fully invested in equities (and never reallocated back to bonds later), the results actually improve3.
In fact, as our research on partial annuitization showed4, it turns out that much of the benefits being attributed to that bucketing strategy were not about the benefits of annuitization and having cash flows to avoid early withdrawals at all. Instead, the benefits of the strategy were actually primarily attributable simply to the path that the retiree’s asset allocation follows as a result of spending down fixed-income assets in the early years and letting equity exposure rise. We label this the “rising equity glide path” throughout retirement. In other words, it was less about “not liquidating stocks in down markets” and more about “letting equity exposure grow over time” instead. Accordingly, in our latest research paper (“Reducing Retirement Risk With a Rising Equity Glide Path,” Journal of Financial Planning)5, we delve further into this rising equity glide path effect and find that in reality, increasing equity exposure throughout retirement can actually enhance retirement outcomes. Doing so is so effective that the retiree can start more conservative and may even end up with less average equity exposure over their lifetime.
For instance, Figure 1 shows the probability of success (not outliving savings) of various stock/bond asset allocations based on a 4% withdrawal rate approach. The figure uses historical returns with an average annual compound real (inflation-adjusted) growth rate of 6.5% for stocks and 2.4% for bonds. The starting equity exposure is on the vertical axis of Figure 1, and the ending equity allocation is on the horizontal axis. Thus, for instance, a portfolio that starts at 60% in equities and ends at 60% in equities (the intersection of the 60% row and column) has a 93.2% probability of success. However, a portfolio that starts at 30% in equities and finishes at 70% in equities actually has a higher (95.1%) probability of success, not to mention a lower average equity exposure through retirement (an average of only 50% in equities instead of 60%).
When viewing the magnitude of potential failures, we see a similar effect in Figure 2. Looking at how many years the portfolio lasts at the fifth percentile (i.e., how quickly we ran out in money in the worst one-out-of-20 scenarios), the 30% to 70% glide path portfolio lasts for 30 years, while the constant 60% equity exposure portfolio is depleted in 27.7 years (or faster) in the 5% worst scenarios. (It’s worth noting that historically, a 60% stock/40% bond portfolio has never actually failed, implying some potential for time diversification6 or mean reversion that we did not specifically model in our Monte Carlo analysis for this research.)
Wade Pfau , Ph.D., CFA, is a professor of retirement income at The American College and the 2011 recipient of the Journal of Financial Planning’s Montgomery-Warschauer Award. He hosts the Retirement Researcher blog at wpfau.blogspot.com.