Increase Equity Exposure Throughout Retirement
Raising exposure to stocks throughout one’s retirement may reduce both the probability of running out of money and the magnitude of any shortfalls. This finding contradicts the conventional wisdom of reducing exposure to stocks in retirement. The argument for bucking the conventional wisdom is based on what may cause a retiree to run out money.
Wade Pfau of The American College and Michael Kitces, director of research for Pinnacle Advisory Group and a financial industry blogger, looked at various glide paths to see how altering the exposure to stocks throughout retirement would affect ending wealth. The calculations assumed annual withdrawals equating to 4% or 5% of the initial portfolio balance and increased each year for the rate of inflation. Retirement periods of 20, 30 and 40 years were looked at.
Based on their calculations, the optimal allocation to stocks started in the range of 20% to 40% at retirement and gradually rose to between 40% and 80%. The allocation with the highest rate of success started with a 30% allocation to stocks and rose to 80% by the end of retirement. They further found far higher success rates for portfolios starting off in the 10% to 30% equity range and utilizing rising glide paths (increasing the allocation to stocks over time) than static portfolios with 50% or 60% in stocks (as well as portfolios that start with those asset allocations and reduce the equity exposure).
Pfau and Kitces give three explanations as to why this is the case. First, they point out that in the case of a 30-year retirement, the outcome of a retirement portfolio is dictated almost entirely by the inflation-adjusted returns for the first 15 years. Secondly, an investor who retires during a period of poor market performance and gradually increases his exposure to stocks is better positioned to take advantage of a future rebound in stock prices. Third, an investor who retires during a period of good market performance ends up being so far ahead of his financial goals that a subsequent bear market may not matter.
The authors do acknowledge that increasing exposure to stocks may be difficult for seniors in their later years who are not comfortable with the higher levels of volatility. Pfau and Kitces point out that the suggested ending allocation is not far off the traditional 60% stocks/40% bonds mixture. They further suggest using a bucket approach to help alleviate volatility concerns.
Source: “Reducing Retirement Risk with a Rising Equity Glidepath,” Wade D. Pfau and Michael E. Kitces, SSRN, September 12, 2013.