Swedroe: Declining Or Rising Equity Strategy In Retirement?

July 22, 2016

Traditional retirement planning calls for gradually reducing an investor’s equity allocation and increasing the allocation to safe bonds.

Perhaps the most well-known example of this concept is the adage that your stock allocation should be equal to 100 minus your age (or with now-longer life expectancies, 110 minus your age). The gradually declining equity (DE) allocation strategy is used by typical life cycle funds, or target-date funds.

Recently, this conventional wisdom has been challenged. In their paper, “Reducing Retirement Risk with a Rising Equity Glide Path,” published in the January 2014 issue of the Journal of Financial Planning, Wade Pfau and Michael Kitces argue that a rising equity (RE) glide path lowers the probability of failure relative to a DE glide path. In other words, retirees adopting the RE strategy face a lower probability of running out of money in retirement than they would with the DE strategy employed by target-date funds.

Need To Balance Two Competing Issues

In planning for retirement, investors must balance two competing issues. The first is spending too much and risking that you will outlive your savings. The second is unnecessarily suppressing spending and leaving a larger-than-desired bequest. Much has been written on the subject.

One part deals with the spending rate, or what is called the “safe withdrawal rate.” The other part addresses the equity/bond allocation. Until recently, the standard rule of thumb was that a 4% spending rate would result in a minimal chance of outliving your portfolio. Annual spending could be 4% of the portfolio’s starting balance, and then adjusted for inflation so the real spending level could be maintained. The original research in this area assumed an equity allocation of at least 50%.

Unfortunately for today’s investors, the finding that 4% was a safe withdrawal rate was based on historical data, when stock valuations were lower and bond yields were higher. Given currently higher equity valuations (which project lower future returns) and lower bond yields, forward-looking return expectations suggest that a 3% safe withdrawal rate is more prudent for investors with a 30-year horizon.

Of course, those with a greater ability to reduce spending if outcomes in the early years of retirement (the period of most danger) are highly negative can choose a higher withdrawal rate.

Choosing A Prudent Glide Path

Having decided on the withdrawal rate still leaves open the question about choosing the right equity allocation, as well as selecting the most prudent glide path. Javier Estrada contributes to the research with his paper, “The Retirement Glidepath: An International Perspective,” which appeared in the Summer 2016 issue of The Journal of Investing.

Prior literature had focused solely on U.S. data. Estrada provides us with out-of-sample data to avoid the problem that has been called the “triumph of the optimists” (the U.S. outcomes might just have been the lucky draw from an entire basket of possible outcomes). Estrada’s data covered 19 countries over the 110-year period ending in 2009.

For example, Estrada shows that the 4% rule, while demonstrating low failure rates for Canada (0%), New Zealand (0%), Denmark (1.2%), South Africa (2.5%), Australia (3.7%) and the U.S. (3.7%), had a high failure rate in Belgium (50.6%), France (56.8%) and Italy (64.2%). The average failure rate was an unacceptably high 26.4%.

Following is a summary of Estrada’s findings.


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