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Dispatches

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.

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.

Discussion

Thomas Dean from ON posted over 12 years ago:

I'm glad you gave us a head's up on this issue. It seems clear to me that an a stock portfolio with a number of holdings in different kinds of businesses will serve better for retirement income than investments focused on interest or dividends. You do have to manage the portfolio, of course. For example, the AAII Shadow Stocks Portfolio seems to provide reasonable returns for people looking for a set of good choices in stocks.


Paul Faya from MD posted over 12 years ago:

My portfolio contains a variety of funds giving me a wide exposure to U.S, and foreign stocks along with some domestic companies that are great for high and increasing dividends. With this mix I have found no need for bonds even during the last two crashes.


Joseph Hehir from NY posted over 12 years ago:

What happens when the equity market tanks? Maybe seniors know something the authors don't.


Harry Rich from OH posted over 12 years ago:

I reply to Joseph Hehir that historically when the equity market tanked you stayed in it. If you held a diversified portfolio you, in fact, bought more equities in re-balancing your portfolio. Then you came out whole when it recovered. This worked for me during the last two down markets as it did for Paul Faya. This is one of the reasons why drawing rates greater than 4% don't work in models based on this history. Higher draws damage your portfolio when it is in the cellar. However, I agree with Joseph's caution. The deflationist economists make a good point: we are experiencing dramatic changes in the way the economy works and cannot safely base our investment decisions entirely on the way the economy has acted throughout our lifetimes.


PETER M from MN posted 4 months ago:

One possible validation of Pfau's and Kitces' article is to look at how people who retired in the period 2018 to 2020 did. How does the current portfolio of those who retired in that period compare to the value of their portfolios at retirement? It would be interesting to see those ratios categorized by % of assets held in equities.


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