Morningstar Magazine - February/March 2014 - (Page 14)

Ivory Towers Rethinking the Path to Retirement By John Rekenthaler A new study says retirees should actually increase their equity exposure late in life. Last autumn, Michael Kitces of Pinnacle Advisory Group presented Reducing Retirement Risk with a Rising Equity Glide-Path at the FPA Experience 2013 conference. The paper, co-written with The American College's Wade Pfau and published in the Journal of Financial Planning (January 2014), takes a fresh look at asset-allocation policy during retirement by advocating that investors own more equities as they get older. Their reasoning: Retirees will be in good shape if stocks perform well throughout retirement. They also have little danger if stocks enjoy an early bull market, but struggle later because the big bulge from the initial bull boosts portfolio values and provides a margin of safety. The primary danger to withdrawal strategies, then, comes from an initial bear market, when stocks get hit shortly after the investor retires. The danger of an early bear market to retirees is not news to most advisors. What is different, however, is the authors' willingness to follow that idea to its logical conclusion. If the major concern is indeed an imminent bear market, they reason, then why not begin retirement with a relative small equity position and grow it over time? That way, the investor's portfolio will have a better chance of recovering from early losses. (This principle holds true if stock returns are 14 Morningstar February/March 2014 fully independent, but the effect is even stronger if stocks are mean-reverting.) To test the thesis, the authors generated Monte Carlo simulations for two relatively high annual withdrawal rates, 4% and 5%, to fund a 30year retirement at three capital-market expectations: 1) the historical data from 1926-2011; 2) an estimate from Harold Evensky, founder of advisory Evensky & Katz, that slashed expected stock returns by 300 basis points per year and bonds by 80 basis points; and 3) an even more conservative forecast that cut stock returns slightly further and took bonds' real returns to nothing. The exhibits illustrate three examples of the findings, taken from the authors' paper. Each table shows the success rate for the simulations under various conditions, with success defined as the initial wealth being able to fund the scheduled withdrawals for each of the 30 years. Next to the success rate in parentheses is the amount of the shortfall when the simulation suffers a bad draw, defined as the 95th percentile. The shortfall is expressed in years. For example, 4 means that in a 95th-percentile simulation, the initial wealth is exhausted four years ahead of schedule, in year 26. The findings were affected by both the chosen asset allocation and the desired withdrawal rates. At a low level of equities-say, an average of 25% throughout the retirement period-there was no discernible advantage in switching from the traditional approach to a rising glide path. Nor was there benefit when using a 5% withdrawal rate. At moderate to high stock allocations, though, and using the more reasonable withdrawal rate of 4%, there were clear benefits to using a rising glide path. The charts differ by the amount of equities. Exhibit 1 shows the totals for a relatively high 45% average position in stocks. The rising glide path begins with 30% in stocks, increases equities by one percentage point per year, and finishes at 60%. The declining glide path is the reverse, starting at 60% and ending at 30%. The flat glide path consists of 45% stocks and 55% bonds throughout the 30-year period. This conclusion held across all three sets of market expectations, suggesting that as long as stocks follow the basic pattern of having higher returns and higher volatility than bonds, the paper's results can be generalized. The approaches in Exhibit 2 and Exhibit 3 mimic that of Exhibit 1. The average positions in stocks are 55% and 75%, respectively. In Exhibit 2, the rising glide path begins with 40% in stocks. In Exhibit 3, it starts with 60% in stocks. Both amounts increase by one percentage point per year for 30 years. The declining glide paths are mirror images. The flat glide path in Exhibit

Table of Contents for the Digital Edition of Morningstar Magazine - February/March 2014

Morningstar Magazine - February/March 2014
Letter From the Editor
Preparing for the Next 50 Years
Morningstar Managers of the Year
Fixing the Trust Deficit
Rethinking the Path to Retirement
Same Old, Same Old
Global Briefs
The Economic Implications of an Older World
Banking on Performance
Is the Affordable Care Act Healing Health Care’s Woes?70
Baxter Has a Positive Prognosis
Leading Fidelity’s Charge for RIAs
Our Favorite Mutual Funds
50 Most-Popular Equity ETFs
Undervalued Stocks With Wide Moats
Moving the Goal Post

Morningstar Magazine - February/March 2014