Rather than counselling clients to shift their assets from stocks to bonds as they age, you should be encouraging retirees to increase their equities allocation over time, according to a recent research paper.
In a paper entitled Reducing Retirement Risk with a Rising Equity Glide Path, Wade Pfau, professor at the Pennsylvania-based American College of Financial Services, and Michael Kitces, research director at Pinnacle Advisory Group Inc. in Maryland, attempted to determine the appropriate equities “glide path” for client portfolios during retirement.
These two researchers found that a U-shaped glide path in retirement – in which equities are at their lowest allocation during the retirement transition, then rise afterward – can be expected to reduce both the probability and magnitude of failure in client portfolios.
According to the paper: “Across all time horizons and withdrawal rates, when examining the approach that provides the highest sustainable withdrawal rates, given a prospective 10% failure rate, the results consistently show support for rising equity glide path portfolios.”
In this analysis, a client’s equities allocation is trimmed in the years leading up to retirement, as is typical. The paper suggests a starting point in retirement of about 20%-40% equities, with a gradual increase to a maximum 60%-80% allocation to stocks.
The results of this strategy, when modelled relative to the success of a 4%-5% inflation-adjusted withdrawal rate, for example, varied depending on the details of the return assumptions and the target spending level.
The more modest the return assumptions, the less difference a rising equities glide path makes.
Even in a worst-case scenario, the researchers found that retirees who start with 30% in equities and slowly increase that allocation by one percentage point a year would be able to withdraw 4% of their portfolio for about 30 years.
More important, a portfolio that starts with 30% in equities and finishes with 60% performs better than a portfolio that starts and finishes with 60%. In other words, clients don’t end up with any more equities exposure than they would have had otherwise – they just start with less.
The research paper acknowledges that the success of such a retirement model is heavily influenced by the sequence of returns. If returns are strong early, clients will be so far ahead relative to their original goal that a subsequent drop in performance will have minimal impact. If the market performs poorly later in retirement, the damage to the portfolio will be much less severe, as the assets will have enjoyed several years of strong performance first.
At the very least, the paper suggests, a rising equities glide path is a simple way to ensure that your clients add to equities when valuations become cheap (i.e., returns are poor), particularly during the first half of their retirement.
But many retired clients may find it difficult to stick with this strategy, particularly when markets are declining.
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