Wade Pfau, Ph.D., CFA, RICP®

To Rise or Not To Rise: Stock Allocation During Retirement

Both the February and March 2015 issues of the Journal of Financial Planning include articles which address and extend the work on rising equity glidepaths during retirement, which Michael Kitces and I published in the January 2014 issue.

Admittedly, the March one is also by us, and I’ll get to that it an moment, but the February article challenges the rising equity glidepath concept and is by David Blanchett.

David does a number of things differently in his article, but there is one portion (Table 2) where he discusses probabilities of success for different strategies which allows for an easier way to compare his results with our methodology. With a 4% withdrawal rate, he finds that declining equity glidepaths in retirement support higher probabilities of success than fixed equity glidepaths, which in turn supports higher probabilities of success than rising equity glidepaths. This finding contrasts with an earlier 2007 article he wrote comparing fixed equity allocations to declining equity allocations, and it also contrasts with our 2014 article.

Why this different finding? It turns out that this difference is being driven by his capital market expectations, which allow bond yields to be lower like they are at present, but which allow bond yields to gradually increase over time toward their historical averages. This is indeed a better way to do Monte Carlo simulations, and I now also use a similar approach in my own work, including at the Retirement Dashboard. When Michael and I wrote our initial article, we included three sets of capital market assumptions with a range of stock and bond returns, but we hadn’t yet built in a mechanism to allow average bond yields to change over time.

I re-ran the analysis that Michael and I did in our initial article, but I switched to the new capital market assumptions I use which allow for increasing bond yields over time while keeping a fixed average equity premium over bonds. I could match up the findings David discussed in his article. It does indeed seem that retiring at times with particularly low bond yields, which can be expected to increase over time, may not favor rising equity glidepaths during retirement. It essentially causes the retiree to lock in low bond returns and even capital losses on a bond fund as bond yields gradually increase (on average) over time.

This is not to say that rising equity glidepaths are never a good idea, though. David includes additional analysis testing glidepaths including a wide variety of scenarios and assumptions, and he continues to find a general trend in favor of declining glidepaths. While I have not fully replicated that part of his paper, I do think it is reasonable to conclude that this is all being driven by the capital market expectations. If interest rates were at a higher initial starting point, I’m guessing that rising glidepaths would look much better in his analysis. This would be an interesting point for him to address in the future.

Now on to the new article by Michael and I in the March JFP. Though we hadn’t read David’s article when we wrote ours, I do think that the articles are somewhat compatible. In our new article, we switch to rolling historical periods, rather than using Monte Carlo simulations. And while we didn’t think to test the results for environments with different initial interest rates, we did test the results for environments with different initial stock market valuation levels. We also do find that the choice of glidepath is not always fixed, as it does vary with the stock market valuation level at the time of retirement.

As we wrote, our results suggest that the valuation-based approach is generally superior to the rising equity glidepath approach and the fixed equity allocation portfolios, as the valuation-based scenarios produce comparable-to-slightly-better results across the board. For those who are willing to be even more flexible, there appear to be further benefits to potentially widening the valuation-based adjustments further (expanding or eliminating the bounding thresholds), though such an approach would have to be managed against a person’s risk tolerance and willingness to deviate so significantly from an underlying allocation benchmark. And in all but the most favorable valuation environments, retirees should consider more defensive bond allocations – i.e., bills as opposed to longer-term bonds – as even with valuation-based adjustments, stock/bond portfolios underperformed stock/bills portfolios from unfavorable and moderate starting valuations.

Another important point in that summary is that we did look at both short-term (6 month or 1 year) bonds as well as 10-year bonds in our analysis, and we found that the shorter-term bonds were of much greater help than longer-term bonds. When the focus is on protecting from downside risks, the additional volatility caused by the 10-year bonds hurt retirement outcomes by more than could be compensated by their higher average yields. This ties into David’s article as well, since his bond allocation was 75% to (I believe) 10-year bonds, and 25% to cash. Again, I wonder what his results would have been if those ratios were switched?

Ultimately, this brings up an interesting dilemma.

Today interest rates are at historical lows and stock market valuations are quite high.

Michael and I look at the market valuation component without specifically considering the interest rate component, and we determined that this is the time when rising equity glidepaths have tended to provide the best results for historical retirements. Meanwhile, the historical data really doesn’t provide much in the way of examples for times when both stock valuations were high while bond yields were simultaneously low.

Meanwhile, David looks at the lower interest rate component without specifically considering the high stock market valuation component (his capital market expectations are described in Appendix 1, and his stock returns are not related to past stock returns), and he concludes that declining equity glidepaths are best. But also, our subsequent research suggests that 10-year bonds may not be the appropriate choice in retirement anyway.

Do remember that ultimately, this whole discussion is about appropriate default glidepaths for those who have very little interest in investments… what should target date funds do post-retirement? Those with greater sophistication should be determining asset allocation based on their funded ratio, and should also be thinking more broadly about the role of income annuities and other strategies.

But, David has produced an interesting article which suggests more research is needed on this topic.

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