Retirement Risk, Rising Equity Glidepaths, and Valuation-Based Asset Allocation
Michael Kitces and I have completed a new research article called, “Retirement Risk, Rising Equity Glidepaths, and Valuation-Based Asset Allocation.” It’s now available as a working paper at SSRN.
This morning, as well, Michael has written a detailed overview of the research at his Nerd’s Eye View blog. A funny point about that. With our last article, I think a lot of people became familiar with it from Michael’s blog post. Twice now, I’ve been speaking to groups of financial planners, and someone has asked me if I’m aware of the recent research about rising equity glidepaths in retirement. Everyone gets a good laugh as I awkwardly answer that I am aware of the research, since I’m actually one of its co-authors.
In order to avoid overlapping too much with Michael’s excellent overview, let me take a different angle in an attempt to summarize this new research article. It all begins with sequence risk, which is the idea that even if the average market return is decent, retirees are especially vulnerable to the impact of bad market returns in the early part of their retirement. Sequence risk is uniquely caused by the attempt to (1) spend a constant amount each year from (2) a volatile investment portfolio. Sequence risk can be dampened by either letting spending fluctuate or by reducing portfolio volatility. For this research, we are focused on the ‘reducing portfolio volatility’ side of the equation.
Outside of just using a low equity allocation throughout retirement (which leads to its own sets of risks in terms of potentially being locked out of any possibility to meet one’s spending goals), we can identify three major ways to reduce portfolio volatility when it counts the most:
(1) rising equity glidepath: reduces portfolio volatility in the pivotal years near the retirement date when a retiree is most vulnerable to losing the most dollars of wealth with a given market drop. People are most vulnerable and have the most at stake when their wealth is the largest.
(2) valuation-based asset allocation: reduces the stock allocation when the portfolio is the most vulnerable to experiencing a big decline in value, which historically has happened when Robert Shiller’s cyclically-adjusted price earnings ratio has risen to levels well above its average (i.e. 1929, the mid-1960s, and 2000).
(3) funded ratio: Reduces 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, that’s when they can invest more aggressively with a volatile portfolio. In other words, reduce volatility when you are most vulnerable to a transition from being able to meet your goals to not being able to meet your goals.
This new research focuses more on the interplay between using different glidepaths and using valuation-based asset allocation.
We clarify that the rising equity glidepath does not necessarily have to be used as a universal situation. However, today’s investing environment does reflect the circumstances when the rising glidepath is most useful. That is, the stock market is overvalued and is more vulnerable to a significant drop. This is when the rising glidepath works best: it lowers the stock allocation to help guide through the environment when the retiree is most vulnerable to a market drop, and presuming such a drop happens at some point, it will then be shifting to a higher stock allocation later in retirement when markets are more fairly valued. In other words, it approximates a valuation-based asset allocation strategy.
When markets are not overvalued, which does not reflect the situation today, then retirees might look more carefully at just holding a higher stock allocation, or at using a valuation-based asset allocation strategy. If markets are undervalued, the traditional type of declining equity glidepath in retirement can actually look more attractive, as it provides a closer proxy to what would be done with a valuation-based strategy.
In conclusion, in today’s overvalued market environment, retirees can reduce their vulnerable to the effects of a big drop in the stock market by using a lower equity allocation. This can be accomplished either by using a pre-set rising equity glidepath (as an inverse of what today’s target date funds do for the pre-retirement period), a valuation-based strategy, or even a combined rising equity glidepath with a valuations overlay. This is the subject of our new article at SSRN.