Arnott: The Glidepath Illusion

September 25, 2012

 

What’s the Alternative?
So, the Glidepath strategy gives us a pretty uncertain retirement nest egg after 40 years of careful savings, with a pretty uncertain spending stream. Even as retirement looms near, it doesn’t give us much confidence about our retirement prospects or lifestyle. So what? Markets are uncertain. At least we can have more confidence and a safer outcome by ramping down our risk late in life than by any other plan, right? Not true.

Consider another investor, Balanced Burt, who is uncomfortable choosing between equities and bonds and thus decides to maintain a steady course at 50/50, for life. Looking at Table 1, we see that Burt winds up with an average outcome that is 10% better than Polly’s, with an average portfolio of $137,870 (versus $124,460) and an average annuity of $8,550 (versus $7,730). In addition, his worst case is better than hers, as is his 10th percentile outcome, and median outcome; only the single best outcome doesn’t improve in portfolio value, but even that outcome improves in the annuity that he can buy. It is no surprise that Burt’s final 10-year change in retirement income becomes less stable than Polly’s; he is finishing his career with more money in the riskier market. The ratio between 10th and 90th percentile outcome jumps from a 3.5 ratio for Polly to a 3.9 ratio for Burt. This improvement happens entirely from the best outcomes getting better; the worst outcomes do not get worse!

Now consider another investor, Contrary Connie, who is skeptical of the standard retirement strategies—either a balanced portfolio or a Glidepath approach. Connie rationalizes that if a static 50/50 strategy is better than a Glidepath strategy, an Inverse-Glidepath strategy might be more appropriate for meeting her goals than either of the “standard” options. It should come as no surprise that this counterintuitive strategy beats a static 50/50 portfolio by essentially the same margin that static 50/50 beats Glidepath. Contrary Connie beats Prudent Polly by ramping up her risk late in life when the portfolio is already large. Connie finishes with an average portfolio of $152,060, versus Polly’s $124,460. Connie’s worst, median, and best outcomes all trump Polly’s. Connie has to accept more uncertainty late in life as to how much she can spend in retirement—but it’s upside uncertainty!

Critics may argue—correctly—that past is not prologue. This outcome is presumably due to higher real returns for stocks and bonds later in the 141-year period (for example, during the immense bull market from 1982 through 1999), leading to a slight tendency for investors to benefit from ramping up risk later rather than earlier in life. To address this criticism, we put the 141-year history into a lottery, with each year’s returns randomly drawn. It delivers the same relative ranking for the merits of Glidepath versus static 50/50 versus Inverse-Glidepath. The inverse finishes on top again!3

Note, if we systematically replace equities with bonds every year so that we are a 50/50 investor at the midpoint of our career, our returns will fall into the same return distribution, over time, whichever path we pursue. Our average allocation will be 50/50 in all three cases! Markets certainly don’t care about our Glidepath, so we’re as likely to have our best stock market returns late in our career as early. If the best stock market returns come early, it’s self-evident that we’ll finish richer with a Glidepath strategy. And, if the best stock market returns come late in our career, we’ll do well to ramp our risk up as our career evolves. But, in our 20s, how can we know whether stock returns will be better early or late in our careers?

Past is Not Prologue
We’ve written extensively about the “3-D Hurricane” that’s bearing down on us, about the importance of ratcheting down return expectations in a world of lower yields, and about the perils of extrapolating the past in order to shape future expectations. Much of this work has proven to be very relevant to investors in recent years. Can we transform this historically rooted test of various formulaic approaches to retirement planning into something that might be relevant today? We probably can.

Rather than hoping for a repeat of the past, with substantial returns earned on a foundation of far higher yields than today’s yields, we should probably shape expectations based on the current outlook. Table 2 seeks to transform the “What if past is prologue?” scenarios of Table 1 to answer a different question: “What if risk in the future resembles risk in the past, but returns in the future are lower to the extent that yields are currently lower than the past norms?” It’s a subtle question, but it’s awfully useful to anyone thinking about setting aside reserves for some future retirement.

 

Accordingly, we make the following adjustments to the data, before we drop it into our lottery tumbler:

  • Cut the average annual historical notional bond return by 2.0% to 1.9%. Long bonds have had an average duration of 15 years. Multiplying the 15 years by the 180 bps yield difference—the gap between the past average and the current real yield—gives us 27% of price appreciation, embedded in the 141 years of history, about 20 bps per annum. This means that bond returns over the last 141 years enjoyed both 180 bps of higher real yield and 20 bps of capital gain from falling yields.
  • Cut the average annual stock return by 2.9% to 5.4%. Stocks have seen dividend yields tumble from an average of 4.5% to 2.1%. This corresponds to a 114% rise in valuation levels. Even though this rise largely occurred over the past 30 years, let’s spread it out over the full 141 years, which gives us 0.5% per year. This means that stock returns over the past 141 years enjoyed both 240 bps of higher dividend yield and 50 bps of capital gain from rising valuation multiples.
  • Cut the real bond yield, which forms the basis for pricing our real annuities, by 180 bps to 90 bps. We hope this doesn’t hold true, because it means that the retirement annuities will be more expensive and our annuities skinnier as a result. But it is the naïve “random walk” assumption from current real TIPS yields.

 

Some might consider these results bleak. We consider them realistic. We can see in Table 2 that today’s newly minted college graduate, choosing to invest on Prudent Polly’s Glidepath, saving $1,000 per year for 41 years, seems likely to deliver a retirement annuity of $2,130 to $5,230. On Contrary Connie’s Inverse-Glidepath, our college grad can plausibly expect a retirement annuity between $2,090 to $6,630, with some slight hope for better results and some small risk of worse.

For those weighing a choice of retiring today versus funding their nest egg for 10 additional years, there’s little difference from the evidence: If we work for a decade longer, we can expect to retire on twice the annuity that we could buy today, give or take a wide range. And there’s less than a 10% likelihood that markets will be so bad in the next 10 years that we’re likely to retire poorer than we could today.

 

 

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