This is the second part in a series of posts that discuss strategies to make retirement plans better. If you haven’t already, please read the intro which discusses what makes a plan “better”, as well as Part 1 which describes why financial planning models may limit your retirement.
This section focuses on one of the primary risks to all financial plans, sequence of return risk, and how we can reduce it.
In the 1990s, Bill Bengen (the financial researcher who invented the “4%” rule) published his first research on safe withdrawal rates, which said it doesn't matter what a retiree's average returns are to determine if their plan will be successful; instead, it's necessary to look at the sequence in which those returns occur. There are numerous historical scenarios where the long-term average may have been healthy, but the sequence meant retirees had to withdraw far less.
Outcomes for a 30-year retirement plan time horizon are driven heavily by the results over the first 15 years (i.e., the first half) of retirement. If the first half of retirement is good, the retiree is so far ahead that a subsequent bear market cannot threaten their retirement goal. Conversely, if the first half of retirement is bad, even if returns average out favorably through retirement, the portfolio is depleted too severely by withdrawals and bad returns in the early years. As a result, there won't be enough money left for when the good returns finally arrive. This is sequence of return risk.
Now consider that and think about the traditional advice that you should get more conservative as you age. That would mean that you are most aggressive precisely when sequence of return risk is highest! This is backwards!
We’ve never believed in the idea that clients should get more conservative as they age, so we’ve picked portfolios that are appropriate for their risk level and plan and encouraged clients to stick with it. That results in a static allocation over time that looks like this:
Clients take withdrawals from their portfolio every year in retirement to pay for things. By holding the allocation static over retirement, we have to sell both stock and bond every time they do to keep the weights consistent. For example, if a client that needs $100k from their 60/40 portfolio, we have to sell $60k in stocks and $40k in bonds.
This brings sequence of return risk back into the equation. If stock returns are bad, we’re selling while they’re down. If they are good, we’re not allowing compounding to work its magic. We focus on stocks rather than bonds, because bonds don’t fluctuate nearly as much as stocks do, and their return is much less and therefore less consequential to the end result.
So how do we make retirement planning and spending better?
Wade Pfau and Michael Kitces are arguably the most respected retirement experts in the world of financial planning. They published a study called, “Reducing Retirement Risk with a Rising Equity Glidepath.” They found that counter to the traditional view of lowering stocks as you age, in reality, increasing equity exposure throughout retirement can actually enhance retirement outcomes.
The primary reason is that even if spending was conservative enough to survive the time period, selling equities throughout flat or declining markets amounts to liquidating while the market is down. Therefore, not being able to participate in the recovery and the next big bull market whenever it finally arrives.
Conversely, with what they call a “rising equity glidepath”, the retiree adds to equities throughout retirement and by the time the market reaches a bottom and the next big bull market finally begins, equity exposure is greater and the retiree can participate even more!
There are a few ways to do this. We can increase a client’s stock allocation by a certain amount each year, say 1%. That would look something like this:
Another option is to put all of your spending in a bucket that is primarily bonds (or other conservative investments) and allow your stock bucket to grow unencumbered. That would look more like this:
Let’s take a client with $2 million that wants to withdraw 4% ($80k growing with inflation) from their portfolio each year. We’ll run two Monte Carlo Simulations (covered in Part 1). The first will maintain a static 60% in stocks every year (static). The second will start with just 40% stock, but only spend out of the bond bucket (dynamic). Here are the results:
What’s less intuitive is that the probability of success went up! This is possible because despite taking more equity risk over the course of a plan, you avoid selling stocks until the later years of the plan when returns aren’t as important. In addition, in the first few years when sequence of return risk is greatest, you are in your most conservative portfolio.
Keep in mind, this is a simple example for an “average” spending client (4%). The real benefit is in the flexibility it allows in how we apply it to each unique client. Some clients spend more than 4%, some spend far less. Some want to spend more money now, some want to leave more later. We can customize the size of the buckets, and how they are invested to find the sweet spot between spending, ending wealth, and the resulting risk of the plan.
Speaking of changing how they are invested, we recently introduced our newest portfolio, Enhanced Growth. The driving force behind rethinking our most aggressive portfolio is this whole line of research. That for many clients, there should be a portion of the portfolio with the single goal of compounding growth, because it’s likely that portion of their wealth has a time horizon that is longer than their lifetime.
In the examples above, I’m simply using the historical stock and bond index characteristics that are used in our benchmarks. Those are chosen as core asset classes to be blended in a portfolio. If we can confidently bucket portions of the portfolio for different objectives, however, we can optimize each bucket for its specific use case. Enhanced Growth is made for specifically for that long-term growth asset, using moderate leverage to enhance the return of stocks, while adding diversification in the process. Something similar could be done in bonds, where you optimize for yield and inflation protection to cover spending needs, rather than for diversifying stock risk in a portfolio.
That last piece, risk, is what I want to end with. We used an example that resulted in a similar probability of success on purpose, as a control to show the tangible benefits of simply reducing sequence of return risk. However, the entire next part of this series is why probability success, and the risk it conveys, is a terrible statistic.
Probability of success implies a binary outcome. You ran out of money, or you didn’t. In reality, any scenario that fails in the simulation wouldn’t have done so if you caught it early and adjusted. Which is of course what happens in real life! We run plans at least every year. If a retirement plan was in jeopardy, we’d know right away and make the necessary changes. Understanding that should empower clients to accept a lower probability of success, which would encourage a larger equity bucket, and thus larger spending and legacy goals.
At WJ Interests, we help you move beyond traditional retirement planning to maximize your wealth and live out your goals. As a trusted resource in Sugar Land, TX, we’re here to guide you toward a confident, meaningful future and lasting legacy.
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