No strategy can make up for inadequate savings or premature retirement.
Young adults should buy stocks; mature adults should favor bonds. Or so we’re taught. It makes intuitive sense. Young people have modest savings and lots of time to recover losses from any bear markets. People approaching retirement have more to lose and less time to recover from bear markets. Typically, they want greater certainty as to how much they can safely spend in retirement and less risk that a decline in the value of their investments will demolish their retirement plans.
This type of logic has spawned a huge retirement planning industry, with a wide array of target-date strategies whose Glidepath mechanisms systematically ramp down portfolio risk as an investor approaches retirement. These products are, for many people, the default option in their 401(k) and other defined contribution pension portfolios. Shockingly, the basic premise upon which these billions are invested is flawed.
Does a Glidepath Lead to Retirement Bliss?
Glidepaths feature equity-centric allocations for younger investors transitioning to bond-centric allocations for retired participants. The basic premise of a Glidepath approach is that a systematic increase in the allocation to bonds over time leads to less risk in our planned spending power in retirement. But does it?
To test the Glidepath premise, we simulate how the approach would have worked in the past. Of course, we do not think it wise to plan for the future by extrapolating the past, but it can be illustrative, particularly on the risk side. We use the 141 years of stock and bond market returns from 1871 to 2011, so our first breadwinner starts working in 1871 and retires at the end of 1911 and our last starts in 1971 and retires at the end of 2011. This gives us 101 worker bees with 101 different investment experiences.1
Consider an investor, Prudent Polly, who plans to save for retirement by investing in a standard Glidepath portfolio. Prudent Polly starts working, fresh out of college, at age 22 and plans to retire at age 63, after working for 41 years. Polly saves $1,000 a year in real terms for each of the 41 years, ramping up contributions with inflation. The first panel of Table 1 shows the ending retirement assets for each option. With classic Glidepath investing, Polly finishes with an average portfolio of $124,460, better than three times the $41,000 that she actually set aside. Because these numbers are adjusted for inflation, Polly has tripled the real purchasing power of her investments. But, there’s a range of outcomes, as evidenced by the $37,670 standard deviation in the results. The standard deviation doesn’t begin to cover the potential range: Polly could have finished with as little as $49,940—scant reward for foregoing $41,000 of spending over her working life—or as much as $211,330. The same savings program gives us a range which offers us 2.4 times more wealth at the 90th percentile than at the 10th percentile.
Because actuaries tell us that Polly should live 20 additional years from age 63, it’s much more important to know how large a lifetime inflation-indexed annuity she can buy than to know the size of her nest egg. The second panel of Table 1 shows the average Ending Retirement Real Annuity—an important measure of Polly’s success. On average, by saving $1,000 per year, indexed to inflation, history suggests that she should expect to have a retirement portfolio that will pay her $7,730 per year for life, also indexed to inflation. Sounds anemic… but then again she was only saving $1,000 per year. Unfortunately, again, there’s a big range. Over the past 141 years, she and her counterparts from past generations could have retired on anywhere from $2,390 to $13,130 per year.
If the Glidepath doesn’t lead to greater retirement assets, perhaps it at least provides Polly with more “visibility” into her likely retirement income, a few years before she retires, because the allocation is becoming far less aggressive (another argument advanced in favor of a Glidepath solution). If this transparency were true, people could plan their retirements with greater confidence. Looking at the last panel of Table 1, we can see that Polly’s annuity at age 63 is 154% larger than it would have been at 53. This is partly because the portfolio nearly doubles in size in that last decade and because she can buy a richer annuity with 20 years’ life expectancy than with 30 years. Unfortunately for Polly, the higher expected annuity is associated with considerable variability around that outcome. Her annuity at age 63 could be 54% less or 1302% greater at 53; the 10th percentile shows almost no change from age 53. This is basically the situation for those who turned 63 in 2011; they could have retired with roughly the same lifetime inflation indexed annuity at age 53 as they would now be able to buy at age 63. Sad, but true.2