as you age by increasing exposure to stocks over the course of retirement.

08 15 ISSUE BRIEF The Case for Increasing Stock Exposure in Retirement By Luke Delorme, Research Fellow Taking on more investment risk defies conventional advice to retirees, but it makes sense for some. Workers who are saving for retirement through IRAs and 401(k)s probably have been asked about asset allocation how much they want to invest in stocks, bonds, or other investments, and the level of risk they are willing to tolerate with their retirement savings. Those who are already in retirement face a new challenge: how to allocate their investments to generate the income they will need for the rest of their life. People have different risk tolerances, different goals, and different financial characteristics. Much popular investment advice has recommended a conservative approach to investing in retirement increasing investments in bonds, decreasing riskier stock investments, and withdrawing funds at a steady, slow pace, often 4 percent. This brief looks at an alternative concept taking on riskier investments as you age by increasing exposure to stocks over the course of retirement. Increasing risk exposure by allocating more to stocks over time is referred to as a rising equity glide path. It starts with a relatively low allocation to equities, say, 20 percent, and gradually increases the exposure to 70 percent over 30 years. This counters conventional wisdom, which advises a lower stock (and risk) exposure as retirees age and their income stream diminishes. Our analysis assesses the value of equity glide paths based on utility, an economic term that refers to the total satisfaction derived from a pattern of income or consumption. We find that rising equity glide paths can improve utility on average, although the improvement is small. We offer two big reasons that rising equity glide paths make sense. In our model, annual spending is constant and savings tend to decrease over time. This means that a retiree s spending as a share of remaining savings tends to increase over time. We will explain why this increasing relative spending amount is the first reason that rising equity glide paths make sense. Also, as savings decline over time, pensions and Social Security become relatively more important sources of income. We will show why higher equity allocations make sense as pensions become more important sources of income. Who should care about equity glide paths? This research targets households that need to get some of their annual income from savings. The household should be looking for a systematic spending strategy that dictates how much to spend every year. This may exclude households with smaller portfolios that will not treat savings as a source www.aier.org AMERICAN INSTITUTE FOR ECONOMIC RESEARCH 1

of regular retirement income. It may also exclude households with very high savings who can comfortably live without spending from principal. This research also targets people who are looking for a constant-dollar spending level. Although there is research suggesting that constant-dollar spending, or spending at the same amount each year, may not be as efficient as dynamic strategies, our experience suggests that many households are still looking for such a guideline. Finally, it is imperative for those who use equity glide paths (and for those who don t) to maintain discipline. When asset allocation fluctuates over time, it can be tempting to make adjustments based on current conditions. The model does not account for temporary adjustments to the glide path. In other words, a rising equity glide path works when it is a smooth, steady ascent. How equity glide paths evolved Researchers and practitioners have long been answering questions about how best to allocate a portfolio for retirement. One platitude says that retirees should decrease exposure to risk, and therefore to stocks, as they age. A rule of thumb has been to allocate 100 minus age percent to equities. This means that a 65-year-old would allocate 35 percent to stocks and a 75-year-old would allocate only 25 percent, with the remainder in safer assets such as bonds, Treasurys, or cash. This pattern sets up a declining equity glide path during retirement. This rule has shifted over time, and many researchers and practitioners began suggesting that retirees maintain a static allocation to equities during retirement. Bill Bengen, the financial adviser who developed the 4 percent withdrawal rule in 1994, used a static 50 percent allocation to stocks during retirement. His research showed that an even higher static allocation to equities, 75 percent, resulted in potentially higher safe withdrawal rates. Targetdate funds, which help workers invest for retirement at a particular date, also follow this static allocation strategy and generally allocate around 40 percent to stocks throughout retirement. Declining and static equity glide paths have recently been called into question. Michael Kitces and Wade Pfau, two popular retirement researchers, have written several articles that show how retirees can modestly reduce risk and improve performance using a rising equity glide path. Our analysis confirms the analysis of Kitces and Pfau using an alternative measurement technique. Measuring retirement outcomes Our analysis looks at the utility derived from simulated income using a measure called the certainty equivalence. To understand certainty equivalence, imagine an income stream that offers a 50/50 chance of either $0 or $60,000 every year. Most people would much prefer stable, guaranteed income. They would forego this uncertain income pattern and accept a guaranteed $25,000 annually because of risk aversion. Therefore, the certainty equivalence of an income stream with a 50/50 chance of $0 or $60,000 every year may be only $25,000, depending on the level of risk aversion. We calculated the certainty equivalence for thousands of simulated retirement income streams. The measure could Starting equity allocation Table 1. Average certainty equivalence for $1 million savings, $0 pension, $40,000 annual withdrawal goal A static allocation yields $34,852, but a rising equity glide path raises that to $35,385. Ending equity allocation (after 30 years) 0% 10 20 30 40 50 60 70 80 90 100 0% 31,215 31,979 32,656 33,230 33,697 34,079 34,343 34,556 34,695 34,775 34,806 10 32,862 33,467 33,990 34,412 34,713 34,946 35,097 35,178 35,218 35,186 35,127 20 33,949 34,412 34,773 35,045 35,220 35,333 35,380 35,385 35,351 35,281 35,181 30 34,525 34,841 35,075 35,228 35,326 35,360 35,354 35,317 35,244 35,143 35,028 40 34,715 34,921 35,054 35,136 35,183 35,188 35,141 35,073 34,982 34,866 34,727 50 34,638 34,769 34,858 34,884 34,896 34,852 34,801 34,715 34,608 34,475 34,331 60 34,401 34,478 34,517 34,510 34,485 34,423 34,346 34,258 34,133 33,996 33,854 70 34,049 34,083 34,083 34,061 34,006 33,937 33,842 33,734 33,608 33,462 33,306 80 33,626 33,631 33,612 33,561 33,486 33,402 33,307 33,184 33,049 32,896 32,738 90 33,152 33,125 33,089 33,026 32,945 32,858 32,737 32,611 32,470 32,311 32,148 100 32,644 32,608 32,561 32,476 32,396 32,291 32,169 32,040 31,889 31,731 31,566 2 ISSUE BRIEF AUGUST 2015

Chart 1. Average certainty equivalence: $1 million savings, $0 pension, 20 70% rising equity glide path $40,000 30,000 20,000 10,000 $35,488 4.2% 0 3% 4 5 6 7 8 9 10 then be used to directly compare different hypothetical outcomes. The best results from our model happened when people didn t run out of money but also didn t massively under-spend. We looked at the average certainty equivalence from our simulations for each equity glide path, weighted by mortality probabilities. This is a different way to compare glide paths than the success rate measure used by Kitces and Pfau. Their success rate simply assesses the likelihood that a particular strategy would run out of money after 30 years. Our complete equation can be found in the May 2015 Journal of Financial Planning article titled, Confirming the Value of Rising Equity Glide Paths: Evidence from a Utility Model, or AIER working paper WP002. Constant-dollar withdrawal rate Glide path performance We started by looking at which glide path provided the best results for a 4 percent constant-dollar withdrawal on a $1 million portfolio, assuming no pension income. This withdrawal pattern, specified by the 4 percent rule, allows for spending $40,000 every year until savings run out. The certainty equivalence with this spending pattern would be the full $40,000 if savings never ran out in the simulations. However, it is unlikely that savings would never run out in any situation, because people may live longer than expected or market returns may be poor. We found that the best results happened when we started with a 20 percent equity allocation and built to 70 percent over 30 years (Table 1). The average certainty equivalence of this strategy is $35,385. 1.5 percent worse that the optimal glide path. This small difference suggests that there are many reasonable equity glide paths with these return assumptions and a 4 percent withdrawal. However, rising equity glide paths, those in the top right of the table, tend to be better than declining or static equity glide paths. This result is consistent with the baseline results provided by Kitces and Pfau, who found the top-performing glide path rises from 30 to 70 percent. Kitces and Pfau also found that the success rate improves only by one percentage point, from 94.1 to 95.1 percent, compared with a static 50 percent allocation. Withdrawal rates The asset allocation decision should not be made independently from the withdrawal rate decision. What happens when we allow the withdrawal rate to change from our original 4 percent? In our baseline scenario, we found that if we increased the withdrawal rate to 4.2 percent, the certainty equivalence increased to $35,488 (Chart 1). Spending $42,000 per year would cause savings to run out in about 29 percent of 30-year scenarios. However, when combined with actual life expectancies, we found that this pattern, applied to opposite-sex married households in which both members retire at age 65, would cause only about 15 percent to completely exhaust savings. This represents a balance between the potential for running out of money and the potential for under-spending during retirement. For comparison, the average certainty equivalence of a static 50 percent allocation to equities is $34,852, about www.aier.org AMERICAN INSTITUTE FOR ECONOMIC RESEARCH 3

Chart 2. Optimal static equity allocation (left) by constant-dollar withdrawal rate With a higher-than-4% withdrawal rate, utility is improved with a higher equity allocation. 100% 90 80 70 60 50 40 30 20 3.6% 3.8 4 4.2 4.4 4.6 4.8 5 5.2 5.4 5.6 5.8 6 Note: Assumes $0 pension income. For a household that needs a higher withdrawal rate, it may be optimal to allocate investments more aggressively to stocks. A high allocation to equities gives the best chance, on average, for savings to last when a high withdrawal rate is needed. Chart 2 shows that if you have to withdraw more, it is optimal to be riskier with investments. In order to separate the effects of withdrawal rates, we look here only at the static equity allocation, with the understanding that a rising equity glide path may help incrementally. This is the first justification for the benefit of rising equity glide paths. For example, let s say you spend $42,000 per year, adjusting upward for inflation. Your assets will decrease over time as you spend from principal. The same $42,000 every year will become Constant-dollar withdrawal rate a larger share of your remaining assets. This higher percentage withdrawal suggests a higher equity allocation over time, aligning with a rising equity glide path. Including pension income We now look at results when pension income is included. Although few people working today will receive a corporate pension, most will receive Social Security, and many households nearing retirement have some remnant of a pension. The Survey of Consumer Finances, a triennial Federal Reserve Board survey of household finances, shows that about half of households aged 55 to 64 expect to receive between $30,000 and $50,000 per year in guaranteed retirement income, inclusive of Social Security. Guaranteed income should have the effect of increasing the optimal withdrawal rate and equity allocation. The logic is straightforward: A household may be willing to take more investment risk with savings when failure still leaves the household with some guaranteed income, as opposed to none. Exhausting savings and having no income must be avoided at all costs, whereas exhausting savings and having $40,000 income is slightly more tolerable. This is one of the central points of a 2011 paper in Financial Analysts Journal by finance professors and authors Moshe Milevsky and Huaxiong Huang, Spending Retirement on Planet Vulcan: The Impact of Longevity Risk Aversion on Optimal Withdrawal Rates. When we include $40,000 of guaranteed income, the optimal withdrawal rate with a static 50/50 portfolio is 5 percent. It is higher than the 4.2 percent we found earlier because the utility-maximizing household is willing to tolerate increased risk since the downside is not as calamitous. The optimal glide path also increases exposure to equities, starting with an allocation of 40 percent and increasing to 80 percent (Table 2). Again, the household is more willing to tolerate asset risk because of the safety net provided by the guaranteed income. We confirmed in our model that the optimal withdrawal rate and equity allocation increase as guaranteed income increases compared with savings (Chart 3). This is the second reason that rising equity glide paths make sense. In the model where households spend from savings over time, guaranteed income becomes relatively more important. When guaranteed income is the primary component of retirement income, it is optimal to accept more risk with greater exposure to equities. 4 ISSUE BRIEF AUGUST 2015

Chart 3. Optimal withdrawal rate (bottom) and static equity allocation (left) by guaranteed income amount Both the optimal withdrawal rate and equity allocation rise with higher yearly income. 70% 60 50 40 30 20 10 0 $0 guaranteed Why a rising equity glide path may be optimal How should retirees think about asset allocation during retirement? Although the answer will vary by household, this brief provides two mathematical explanations for why rising equity glide paths may be right for some households. Although the overall improvement 4% 4.2 4.4 4.6 4.8 5.0 5.2 5.4 5.6 5.8 6 Note: Assumes $1 million savings. $20,000 $40,000 $60,000 $100,000 in utility is small, sophisticated investors, advisers, and planners will be looking for ways to get any advantage they can with retirement savings. First, calibrating an appropriate withdrawal rate is critically important for maximizing utility. The withdrawal rate and equity allocation decisions must be coordinated. A higher withdrawal rate may require a more aggressive equity allocation. Likewise, a higher equity allocation may allow for a higher withdrawal rate. If retirees are spending from principal, as they are in our model, a constant-dollar withdrawal will become a higher percentage of the remaining portfolio. As the withdrawal percentage increases, we have shown it is optimal for the allocation to equities to increase as well, consistent with the rising equity glide path. Second, the results from this paper and others show that optimal equity allocations and withdrawals increase as the ratio of guaranteed income to savings increases. Again, this is consistent with the advantages of the rising equity glide path. If retirees are spending from principal, pension and Social Security income become relatively more important sources of income. The logic follows that it is optimal to increase exposure to equities as savings shrink. These results highlight two reasons that help explain why rising equity glide paths may be optimal for many households. ) Table 2. Average certainty equivalence for $1million savings, $40,000 pension, $50,000 annual withdrawal goal With $40,000 in guaranteed income, the optimal equity glide path starts and ends higher. Ending equity allocation (after 30 years) Starting equity allocation 0% 10 20 30 40 50 60 70 80 90 100 0% 73,402 73,986 74,558 75,111 75,659 76,158 76,636 77,066 77,451 77,791 78,092 10 75,145 75,690 76,239 76,739 77,198 77,631 78,003 78,351 78,628 78,855 79,041 20 76,625 77,130 77,585 78,013 78,406 78,744 79,026 79,259 79,432 79,554 79,648 30 77,814 78,227 78,606 78,941 79,221 79,456 79,638 79,778 79,875 79,916 79,940 40 78,640 78,975 79,274 79,502 79,702 79,828 79,934 80,012 80,030 80,020 79,996 50 79,175 79,419 79,618 79,773 79,886 79,960 79,982 80,003 79,993 79,967 79,907 60 79,408 79,578 79,705 79,798 79,852 79,877 79,877 79,861 79,821 79,758 79,683 70 79,442 79,563 79,636 79,668 79,682 79,680 79,647 79,602 79,539 79,461 79,368 80 79,324 79,383 79,405 79,418 79,409 79,385 79,329 79,258 79,186 79,086 78,969 90 79,100 79,116 79,118 79,102 79,064 79,007 78,941 78,862 78,765 78,653 78,545 100 78,795 78,784 78,756 78,717 78,655 78,581 78,492 78,403 78,293 78,173 78,041 www.aier.org AMERICAN INSTITUTE FOR ECONOMIC RESEARCH 5

Gain new insight on the U.S. and the world economy Join us for free lectures by two distinguished speakers preceding performances at our Stone House ballroom by New York City s Ensemble for the Romantic Century. Wed., Aug. 26, 4:30 p.m. The Hon. J. William Middendorf II National Security and the European Economy 7 p.m., Ensemble for the Romantic Century Van Gogh s Ear Fri., Aug. 28, 2015, 4:30 p.m. Dominick Salvatore Growth Prospects for the United States and the World Economy 8 p.m., Ensemble for the Romantic Century Van Gogh s Ear Tickets for Van Gogh s Ear, an original theatrical concert based on artist Vincent Van Gogh s letters to his brother Theo, are available for purchase from our performance partner, the Clark Art Institute, www.clarkart.edu/events. This production is made possible, in part, by the generous support of American Investment Services, Inc. About the speakers J. William Middendorf II is a veteran of many political campaigns and has served three U.S. presidents. President Richard Nixon named him U.S. ambassador to the Netherlands. In President Gerald Ford s administration he served as Secretary of the Navy, and President Ronald Reagan named him ambassador to the OAS and later, ambassador to the E.U. He was one of the architects of the North American Free Trade Agreement. He is also an author and composer, writing The Origins of the Conservative Movement and composing numerous symphonies and marches. Dominick Salvatore, distinguished professor of economics and department chair, Fordham University, has published 57 books and more than 100 articles in leading economic journals. He is the author of texts on international economics, managerial economics, and microeconomics. He is a consultant to the U.N., the World Bank, and the IMF, among others. A fellow of the New York Academy of Sciences and past chairman of its economics section, in 2010 he was nominated for the National Medal of Science. About the American Institute for Economic Research: The Issue Brief is published by The American Institute for Economic Research (AIER), a nonprofit, scientific, educational, and charitable or ganization. The AIER provides factual, unbiased research and critical analysis on economic and financial topics. We educate individuals on how to protect their interests and to make informed decisions for a better America. For more information or to become an Annual Sustaining Member: Call: 413.528.1216 Visit: www.aier.org American Institute for Economic Research PO Box 1000 Great Barrington, MA 01230 Find us on: Facebook facebook.com/americaninstituteforeconomicresearch Twitter twitter.com/aier LinkedIn linkedin.com/company/american-institute-for-economic-research Copyright 2015 American Institute for Economic Research. Reproduction with permission is encouraged. Economics for Everyone The American Institute for Economic Research produces unbiased, expert insight and analysis that enables people to protect their economic and financial interests and those of the nation. Our Impact AIER is a reliable source of information people need to make sound economic and financial decisions, avoid costly mistakes, and support sensible public policy solutions. Become a Member Help AIER improve economic and financial literacy in America. Visit Call www.aier.org 1.888.528.1216