asset allocation retirement researcher

Last week, I discussed the pros and cons of a rising equity glide path approach to asset allocation in retirement. This week, I want to finish that discussion by looking at two other options.

A second approach to dynamic asset allocation is to use valuation-based asset allocation. The idea for this approach is to reduce the stock allocation when the portfolio is the most vulnerable to experiencing a big decline in value, which historically has happened when measures such as Robert Shiller’s cyclically adjusted price earnings (PE) ratio have risen to levels well above their averages (i.e., 1929, the mid-1960s, and 2000).

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A related possibility is to modify asset allocation based on current market valuations. For instance, in my article, “Withdrawal Rates, Savings Rates, and Valuation-Based Asset Allocation,” I investigated a case study comparing a 50/50 fixed asset allocation for stocks and bonds against a strategy that keeps 50 percent stocks as a baseline, but switches to 25 percent stocks when Shiller’s PE ratio rises above 4/3 of its historical average up to that point, and rises to 75 percent stocks when Shiller’s PE ratio falls below 2/3 of its historical average up to that point.

In rolling historical thirty-year periods using Robert Shiller’s data for large-capitalization U.S. stocks and ten-year U.S. government bonds, the valuation-based strategy raised the SAFEMAX withdrawal rate from 3.93 percent to 4.58 percent.

Another article of mine, “Retirement Risk, Rising Equity Glide paths, and Valuation-Based Asset Allocation,” linked the concept of rising equity glide paths with valuation-based asset allocation by focusing more on the interplay between different glide paths and valuation-based asset allocation.

There, my co-author Michael Kitces and I clarify that the rising equity glide path does not necessarily have to be used as a universal situation. However, the current investing environment in 2017 reflects the circumstances when the rising glide path is most useful. That is, the stock market is highly valued and is more vulnerable to a decline.

This is when the rising glide path works to lower the stock allocation to serve as a guide through the years when the retiree is most vulnerable to a market drop.

Presuming such a drop occurs at some point, it will then shift to a higher stock allocation later in retirement when markets are less highly valued. In other words, the rising glide path approximates a valuation-based asset allocation strategy.

When markets are not highly valued, retirees might look more carefully at just holding a higher stock allocation or using a valuation-based asset allocation strategy.

If markets are undervalued, the traditional type of declining equity glide path in retirement can look more attractive, as it provides a closer approximation to what would be done with a valuation-based strategy.

In a highly valued market environment (like 2017), retirees can reduce their vulnerability to the effects of a big drop in the stock market by using a lower equity allocation.

This can be accomplished by using either a preset rising equity glide path (as an inverse of what today’s target date funds do for the pre-retirement period), a valuation-based strategy, or some combination of the two.

It must be noted that implementing a valuation-based allocation strategy requires a certain disposition, as it is a contrarian strategy requiring lower stock allocations when people are most giddy about stocks, and requiring higher stock allocations when panic has set in for the typical investor.

The fact that the strategies “worked” historically does not guarantee future success. Nonetheless, this research proposes a potential asset allocation approach for retirees wishing to incorporate valuations into their asset allocation choices, but also wishing to maintain a formal commitment to an asset allocation decision framework that will hopefully help prevent hasty, emotion-based decisions. At the very least, these findings can help support the psychological discipline to stay the course and not buy high and sell low.

Funded Ratio

Finally, asset allocation can be based on a retiree’s funded ratio.

The point of calculating an individual’s funded ratio is to treat personal retirement planning in the same sort of manner as a corporate pension fund.

Are the lifetime values of assets large enough to meet the lifetime liabilities? The answer to this question is measured through the funded ratio.

A funded status of 100 percent means that a household has just enough assets to meet liabilities. Overfunded and underfunded individuals have more or less than this, respectively.

This approach seeks to reduce portfolio volatility when the retiree has enough assets to just get by with meeting their retirement spending goals using a low-volatility portfolio.

Once the retiree has excess “discretionary” wealth beyond what is needed to safely lock in their goals, they can invest more aggressively with a volatile portfolio.

In other words, reduce volatility when the possibility of meeting your financial goals is most vulnerable to the impacts of a negative market.

Determining your funded status is an important method to help get a feel for whether your retirement plan is on track. Chapter eight will provide more details about using the funded ratio in practice.

A key point for now is that the funded ratio can be used to guide asset allocation, as being overfunded for retirement can provide the capacity to use a more aggressive asset allocation.

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