Asset Allocation Glidepath During Retirement Wade D. Pfau, Ph.D., CFA The American College McLean Asset Management instream Solutions Retirement Researcher blog (wpfau.blogspot.com)
Asset Allocation Methods for Retirement Safe Withdrawal Rates and Fixed Asset Allocations Traditional and Rising Equity Glidepaths Valuation-Based Asset Allocation Valuation-Based Glidepaths Funded Ratio and Asset-Liability Management
Safe Withdrawal Rates & Fixed Aggressive Allocations
The 4% Rule Aggressive Fixed Allocations & Sequence Risk William Bengen Journal of Financial Planning, October 1994
Basis for the 4% Rule Figure 2.1 Maximum Sustainable Withdrawal Rates For 50/50 Asset Allocation, 30-Year Retirement Duration, Inflation Adjustments, No Fees Using SBBI Data, 1926-2010, S&P 500 and Intermediate-Term Government Bonds 9 8 Maximum Sustainable Withdrawal Rate 7 6 5 4 3 2 1 SAFEMAX 0 1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 Retirement Year
Basis for the 4% Rule: Asset Allocation Maximum Sustainable Withdrawal Rate Figure 2.2 Maximum Sustainable Withdrawal Rates For Various Asset Allocations, 30-Year Retirement Duration, Inflation Adjustments, No Fees Using SBBI Data, 1926-2010, S&P 500 and Intermediate-Term Government Bonds 14 13 12 11 10 9 8 7 6 5 4 3 2 1 0% Stocks 25% Stocks 50% Stocks 75% Stocks 100% Stocks 0 1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 Retirement Year
Basis for the 4% Rule 4.5 Figure 2.3 Connection Between SAFEMAX and Stock Allocation 30-Year Retirement Duration, Inflation Adjustments, No Fees Using SBBI Data, 1926-2010, S&P 500 and Intermediate-Term Government Bonds 4 3.5 3 SAFEMAX 2.5 2 1.5 1 0.5 0 0 10 20 30 40 50 60 70 80 90 100 Stock Allocation
Basis for the 4% Rule Median Bequest (Remaining Real Wealth / Retirement Date Wealth) 3.5 3 2.5 2 1.5 1 0.5 0 Figure 2.4 Connection Between Median Bequest and Stock Allocation 30-Year Retirement Duration, Inflation Adjustments, No Fees Using SBBI Data, 1926-2010, S&P 500 and Intermediate-Term Government Bonds 0 10 20 30 40 50 60 70 80 90 100 Stock Allocation
Basis for the 4% Rule Withdrawal Rate Distribution 15 14 13 12 11 10 9 8 7 6 5 4 3 2 1 Figure 2.5 Distribution of Withdrawal Rates by Stock Allocation 30-Year Retirement Duration, Inflation Adjustments, No Fees Using SBBI Data, 1926-2010, S&P 500 and Intermediate-Term Government Bonds Maximum Median Minimum (SAFEMAX) 0 0 10 20 30 40 50 60 70 80 90 100 Stock Allocation
Monte Carlo Simulations
Sequence Risk Most vulnerable to returns when wealth is largest Pre-retirement dollar cost averaging reverses in distribution phase
Problems with 4% Rule Incongruity of funding a smooth spending stream from a volatile portfolio this is a unique cause of sequence of returns risk Solutions: Let spending fluctuate or lower the volatility
Traditional & Rising Equity Glidepaths
Rising Equity Glidepaths (with Michael Kitces) Journal of Financial Planning, January 2014
Traditional Target Date Funds To Retirement 100% 80% Bonds Stock Allocation 60% 40% 20% Stocks 0% 40+ 35 30 25 20 15 10 5 0 5 10 15 20 25 30 35 40+ Years Before Retirement Years After Retirement
Traditional Target Date Funds Through Retirement 100% 80% Bonds Stock Allocation 60% 40% 20% Stocks 0% 40+ 35 30 25 20 15 10 5 0 5 10 15 20 25 30 35 40+ Years Before Retirement Years After Retirement
Financial Planning: Maintain High Stock Allocation 100% 80% Bonds Stock Allocation 60% 40% 20% Stocks 0% 40+ 35 30 25 20 15 10 5 0 5 10 15 20 25 30 35 40+ Years Before Retirement Years After Retirement
Target Date Funds Rising Equity Glidepath 100% 80% Bonds Stock Allocation 60% 40% 20% Stocks 0% 40+ 35 30 25 20 15 10 5 0 5 10 15 20 25 30 35 40+ Years Before Retirement Years After Retirement
100 Fixed 45% Stock Allocation 100 Fixed 60% Stock Allocation 80 80 60 60 40 40 20 20 0 5 10 15 20 25 30 0 5 10 15 20 25 30 Traditional (Declining) Equity Glidepath 100 100 Reverse Equity Glidepath Stock Allocation 80 60 40 20 80 60 40 20 0 5 10 15 20 25 30 0 5 10 15 20 25 30 Accelerated Traditional Equity Glidepath 100 Accelerated Rising Equity Glidepath 100 80 80 60 60 40 40 20 20 0 0 5 10 15 20 25 30 5 10 15 20 25 30 Years Since Retirement
Table 1 Historical SAFEMAX for Different Asset Allocation Strategies over 30-Year Retirement Periods Stocks/Bills Asset Allocations Stocks/Bonds Asset Allocations Fixed 45% Stocks 3.83 3.54 Fixed 60% Stocks 4.10 3.62 Rising Equity Glidepath 3.86 3.53 Traditional (Declining) Glidepath 3.78 3.54 Accelerated Rising Equity Glidepath 4.21 3.59 Accelerated Traditional (Declining) Glidepath 3.44 3.47 Note: The rising equity glidepath transitions from 30.5% stocks to 59.5% stocks over a 30-year period. The traditional equity glidepath transitions from 59.5% stocks to 30.5% stocks over a 30-year period. The accelerated versions of the glidepaths make the same allocation transitions over 15 years (see Figure 1 for an illustration).
12 Figure Maximum Sustainable Withdrawal Rates (MWR) For Stocks and Bills, 30-Year Retirement Periods Maximum Sustainable Withdrawal Rate Difference (Nonfixed - Fixed) 10 8 6 4 2 Fixed 45/55 Asset Allocation Accelerated Rising (30 -> 60) Equity Glidepath 0 1870 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 Retirement Year 2 1 0 (MWR for Non-Fixed Strategy) - (MWR for Fixed Strategy) -1 1870 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 Retirement Year
Table 2 Historical SAFEMAX for Different Asset Allocation Strategies over 30-Year Retirement Periods Segmented by PE10 Market Valuation Levels at the Retirement Date Using Stocks/Bills Undervalued Fairly Valued Overvalued Fixed 45% Stocks 5.05 4.19 3.83 Fixed 60% Stocks 5.37 4.43 4.1 Rising Equity Glidepath 4.84 4.08 3.86 Traditional (Declining) Glidepath 5.22 4.27 3.78 Accelerated Rising Equity Glidepath 4.97 4.43 4.21 Accelerated Traditional (Declining) Glidepath 5.09 3.90 3.44 Using Stocks/Bonds Fixed 45% Stocks 5.01 3.75 3.54 Fixed 60% Stocks 5.33 3.92 3.62 Rising Equity Glidepath 4.79 3.67 3.53 Traditional (Declining) Glidepath 5.22 3.83 3.54 Accelerated Rising Equity Glidepath 4.89 3.74 3.59 Accelerated Traditional (Declining) Glidepath 5.10 3.75 3.47 Note: The note in Table 1 explains the allocations for the various glidepaths. The asset allocations in Figure 1 indicate which years are treated as undervalued (high stock allocation), fairly valued (medium stock allocation), and overvalued (low stock allocation).
Valuation-Based Asset Allocation
Valuation-Based Asset Allocation & Sustainable Withdrawal Rates Journal of Financial Planning, April 2012 (article link)
Robert Shiller s PE10
Minimum Necessary Savings Rates for 12.5x Wealth (Percentage of Salary) 40 35 30 25 20 15 10 5 Figure 4 For 60/40 Asset Allocation, 30-Year Work Period, 30-Year Retirement Period Comparing MSRs and E10/P at Retirement Year Comparing MWRs and E10/P at Retirement Year MSR = 6.57 + 1.63 * E10/P R 2 = 0.88 0 0 5 10 15 20 E10/Y overvalued undervalued Maximum Sustainable Withdrawal Rates (Percentage of Wealth) 10 8 6 4 2 MWR = 2.98 + 0.37 * E10/P R 2 = 0.72 0 0 5 10 15 20 E10/P overvalued Comparing MSRs and MWRs by Retirement Year undervalued Maximum Sustainable Withdrawal Rates (Percentage of Wealth) 10 8 6 4 2 MWR = 1.59 + 0.22 * MSR R 2 = 0.79 0 0 5 10 15 20 25 30 35 40 Minimum Necessary Savings Rates for 12.5x Wealth (Percentage of Salary)
45 Figure 2 PE10 Historical Data with Graham and Dodd Asset Allocation Decision Rule 40 35 PE10 30 25 20 15 10 5 Low Stock Medium Stock High Stock Stocks Percentage 0 1870 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 Year Time Path for Asset Allocation 100 80 60 40 20 Fixed 45/55 Asset Allocation Graham and Dodd 30-45-60 Valuation-Based Asset Allocation 0 1870 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 Year
12 Figure Maximum Sustainable Withdrawal Rates (MWR) Using Stocks and Bills For Fixed and Valuation-Based Asset Allocation, 30-Year Retirement Periods Maximum Sustainable Withdrawal Rate Difference (VBAA - Fixed) 10 8 6 4 2 Fixed 45/55 Asset Allocation Graham and Dodd 30-45-60 Valuation-Based Asset Allocation 0 1870 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 Retirement Year 2 1 0 (MWR for Valuation-Based Strategy) - (MWR for Fixed Strategy) -1 1870 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 Retirement Year SAFEMAX Fixed 50/50: 3.83% Valuation-Based: 4.2%
Valuation-Based Glidepaths
Defining Valuation-Based Glidepaths Bounded Valuation-Based Rising Glidepath Follows 30 60 Glidepath with ±15% valuation adjustment But valuation-adjusts cannot lead to allocation about 30-60% range Bounded Valuation-Based Traditional Glidepath Follows 60 20 Glidepath with ±15% valuation adjustment But valuation-adjusts cannot lead to allocation about 30-60% range Unbounded Valuation-Based Rising Glidepath Follows 30 60 Glidepath with ±15% valuation adjustment Allows stock allocations to potentially range from 15% to 75% Unbounded Valuation-Based Traditional Glidepath Follows 60 30 Glidepath with ±15% valuation adjustment Allows stock allocations to potentially range from 15% to 75%
Table 3 Historical SAFEMAX for Different Asset Allocation Strategies over 30-Year Retirement Periods Segmented by PE10 Market Valuation Levels at the Retirement Date Using Stocks/Bills Undervalued Fairly Valued Overvalued Fixed 45% Stocks 5.05 4.19 3.83 Fixed 60% Stocks 5.37 4.43 4.1 Rising Equity Glidepath 4.84 4.08 3.86 Traditional (Declining) Glidepath 5.22 4.27 3.78 Accelerated Rising Equity Glidepath 4.97 4.43 4.21 Accelerated Traditional (Declining) Glidepath 5.09 3.90 3.44 Valuation-Based Allocation: 30-45-60 5.62 4.50 4.2 Bounded Valuation-Based Rising Glidepath 5.26 4.27 4.04 Bounded Valuation-Based Traditional Glidepath 5.50 4.33 4.06 Unbounded Valuation-Based Rising Glidepath 5.26 4.31 4.23 Unbounded Valuation-Based Traditional Glidepath 5.80 4.47 4.15
12 Figure Maximum Sustainable Withdrawal Rates (MWR) For Stocks and Bills, 30-Year Retirement Periods Maximum Sustainable Withdrawal Rate Difference (Nonfixed - Fixed) 10 8 6 4 2 Fixed 45/55 Asset Allocation Unbounded Valuation-Based Traditional (60 -> 30) Equity Glidepath 0 1870 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 Retirement Year 2 1 0 (MWR for Non-Fixed Strategy) - (MWR for Fixed Strategy) -1 1870 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 Retirement Year
Funded Ratio and Asset-Liability Management
(1) Funded Ratio Management Corporate pension funds & individual retirement Do Household Assets Exceed Liabilities? Assets: Resources Available to Fund Liabilities: current financial assets, home, future income, Social Security, etc. Liabilities: Planned expenditures over lifetime Present value: lifetime income and expenses discounted and summed to a single number Overfunded, Funded, and Underfunded
Michael Zwecher, Retirement Portfolios: Theory, Construction, and Management
Household Balance Sheet Assets Liabilities (Present Values) Human Capital Financial Capital Social Capital Legacy Discretionary Contingency Fixed
Calculating the Value of $10,000 Income Stream for a 65-Year Old Male Discount Rate: 2% Age Income Discount Factor Discounted Value of Income Survival Probabilities* Survival- Weighted Discounted Value 65 $10,000 1.0000 $10,000 1.0000 $10,000 66 $10,000 0.9804 $9,804 0.9838 $9,645 67 $10,000 0.9612 $9,612 0.9665 $9,290 68 $10,000 0.9423 $9,423 0.9480 $8,933 69 $10,000 0.9238 $9,238 0.9283 $8,576 70 $10,000 0.9057 $9,057 0.9074 $8,219 71 $10,000 0.8880 $8,880 0.8852 $7,860 72 $10,000 0.8706 $8,706 0.8615 $7,500 73 $10,000 0.8535 $8,535 0.8364 $7,139 74 $10,000 0.8368 $8,368 0.8097 $6,775 75 $10,000 0.8203 $8,203 0.7815 $6,411 76 $10,000 0.8043 $8,043 0.7516 $6,045 77 $10,000 0.7885 $7,885 0.7200 $5,677 78 $10,000 0.7730 $7,730 0.6867 $5,308 79 $10,000 0.7579 $7,579 0.6518 $4,940 80 $10,000 0.7430 $7,430 0.6154 $4,573............... 100 $10,000 0.5000 $5,000 0.0111 $56 101 $10,000 0.4902 $4,902 0.0071 $35 102 $10,000 0.4806 $4,806 0.0045 $22 103 $10,000 0.4712 $4,712 0.0027 $13 104 $10,000 0.4619 $4,619 0.0016 $7 Present Value of the Annuity = Sum of Survival-Weighted Discounted Values: $147,816 *Survival Probabilities are calculated from the Social Security Administration's 2009 Period Life Table.
Lifetime Financial Plan (in Inflation-Adjusted Terms) for the Brady Family (Social Security at 66) Income Spending Year Age Labor Income Pension Social Security Essential Discretionary 2014 66 $0 $6,000 $54,000 $60,000 $40,000 2015 67 $0 $5,854 $54,000 $60,000 $40,000 2016 68 $0 $5,711 $54,000 $60,000 $40,000 2017 69 $0 $5,572 $54,000 $60,000 $40,000 2018 70 $0 $5,436 $54,000 $60,000 $40,000 2019 71 $0 $5,303 $54,000 $60,000 $40,000 2020 72 $0 $5,174 $54,000 $60,000 $40,000 2021 73 $0 $5,048 $54,000 $60,000 $40,000 2022 74 $0 $4,924 $54,000 $60,000 $40,000 2023 75 $0 $4,804 $54,000 $60,000 $40,000 2024 76 $0 $4,687 $54,000 $60,000 $40,000 2025 77 $0 $4,573 $54,000 $60,000 $40,000 2026 78 $0 $4,461 $54,000 $60,000 $40,000 2027 79 $0 $4,353 $54,000 $60,000 $40,000 2028 80 $0 $4,246 $54,000 $60,000 $40,000 2029 81 $0 $4,143 $54,000 $55,000 $35,000 2030 82 $0 $4,042 $54,000 $55,000 $35,000 2031 83 $0 $3,943 $54,000 $55,000 $35,000 2032 84 $0 $3,847 $54,000 $55,000 $35,000 2033 85 $0 $3,753 $54,000 $55,000 $35,000 2034 86 $0 $3,662 $54,000 $55,000 $35,000 2035 87 $0 $3,572 $54,000 $55,000 $35,000 2036 88 $0 $3,485 $54,000 $55,000 $35,000 2037 89 $0 $3,400 $54,000 $55,000 $35,000 2038 90 $0 $3,317 $54,000 $55,000 $35,000 2039 91 $0 $3,236 $54,000 $55,000 $35,000 2040 92 $0 $3,157 $54,000 $55,000 $35,000 2041 93 $0 $3,080 $54,000 $55,000 $35,000 2042 94 $0 $3,005 $54,000 $55,000 $35,000 2043 95 $0 $2,932 $54,000 $55,000 $35,000
Analysis for the Brady Family (SS @ 66) Funded Ratio Based on Planning Age of 95 Discount Rate (in Inflation-Adjusted Terms) 1.5% Total Assets $2,198,787 Current Financial Assets $800,000 Labor Income $0 Pension $105,601 Social Security $1,293,186 Total Liabilities $2,288,539 Essential Spending $1,383,749 Discretionary Spending $904,791 Funded Ratio (Assets / Liabilities) 0.96 * Discount rate is 30-Year TIPS yield on Jan. 6, 2014
Lifetime Financial Plan (in Inflation-Adjusted Terms) for the Brady Family (Social Security at 70) Income Spending Year Age Labor Income Pension Social Security Essential Discretionary 2014 66 $0 $6,000 $0 $60,000 $40,000 2015 67 $0 $5,854 $0 $60,000 $40,000 2016 68 $0 $5,711 $0 $60,000 $40,000 2017 69 $0 $5,572 $0 $60,000 $40,000 2018 70 $0 $5,436 $71,280 $60,000 $40,000 2019 71 $0 $5,303 $71,280 $60,000 $40,000 2020 72 $0 $5,174 $71,280 $60,000 $40,000 2021 73 $0 $5,048 $71,280 $60,000 $40,000 2022 74 $0 $4,924 $71,280 $60,000 $40,000 2023 75 $0 $4,804 $71,280 $60,000 $40,000 2024 76 $0 $4,687 $71,280 $60,000 $40,000 2025 77 $0 $4,573 $71,280 $60,000 $40,000 2026 78 $0 $4,461 $71,280 $60,000 $40,000 2027 79 $0 $4,353 $71,280 $60,000 $40,000 2028 80 $0 $4,246 $71,280 $60,000 $40,000 2029 81 $0 $4,143 $71,280 $55,000 $35,000 2030 82 $0 $4,042 $71,280 $55,000 $35,000 2031 83 $0 $3,943 $71,280 $55,000 $35,000 2032 84 $0 $3,847 $71,280 $55,000 $35,000 2033 85 $0 $3,753 $71,280 $55,000 $35,000 2034 86 $0 $3,662 $71,280 $55,000 $35,000 2035 87 $0 $3,572 $71,280 $55,000 $35,000 2036 88 $0 $3,485 $71,280 $55,000 $35,000 2037 89 $0 $3,400 $71,280 $55,000 $35,000 2038 90 $0 $3,317 $71,280 $55,000 $35,000 2039 91 $0 $3,236 $71,280 $55,000 $35,000 2040 92 $0 $3,157 $71,280 $55,000 $35,000 2041 93 $0 $3,080 $71,280 $55,000 $35,000 2042 94 $0 $3,005 $71,280 $55,000 $35,000 2043 95 $0 $2,932 $71,280 $55,000 $35,000
Analysis for the Brady Family (SS @ 70) Funded Ratio Based on Planning Age of 95 Discount Rate (in Inflation-Adjusted Terms) 1.5% Total Assets $2,338,000 Current Financial Assets $800,000 Labor Income $0 Pension $105,601 Social Security $1,432,399 Total Liabilities $2,288,539 Essential Spending $1,383,749 Discretionary Spending $904,791 Funded Ratio (Assets / Liabilities) 1.02 * Discount rate is 30-Year TIPS yield on Jan. 6, 2014
Response to Underfunded Status 1. Increase Assets (earn more, work longer, delay Social Security) 2. Decrease Liabilities (reduce spending) 3. Earn Higher Investment Returns (higher discount rate but risky) 4. Monetize Mortality (income annuity)
Modern Retirement Theory by Jason K. Branning, CFP and M. Ray Grubbs, Ph.D. www.modernretirementtheory.com Legacy Fund Assets Funding Priority Fund for Discretionary Expenses Contingency Fund Fund for Essential Needs
Investment Approach Asset-liability matching. Assets are matched to goals so that risk levels are comparable. Lifetime spending potential is the focus, not maximizing wealth Volatile assets are not appropriate for basic needs or contingency fund
Funded Ratio and Asset Allocation Pittman, Sam, and Rod Greenshields. 2012. Adaptive Investing: A Responsive Approach to Managing Retirement Assets. Retirement Management Journal 2, 3 (Fall): 45-54.
Safer withdrawal plan Source: http://www.bobsfinancialwebsite.com/saferplan2.html
Asset Allocation and Funded Ratio in Practice Journal of Financial Planning, February 2013 (article link)
Spending ($) Dedicated Portfolio Distributions Time Segmentation Lifestyle Goal Dedicated Income Diversified Portfolio Age
Spending ($) Dedicated Portfolio Distributions Essentials vs. Discretionary Lifestyle Goal Diversified Portfolio Basic Needs Dedicated Income Age
Systematic Withdrawals Product Allocation Variable Annuities with Guaranteed Living Benefit Riders (GLWBs) Immediate Annuities (SPIAs & DIAs)
Real Value of Financial Assets at Death (Median Outcome) as a Percentage of Retirement Date Assets 80 70 60 50 40 30 20 10 Figure Retirement Income Frontier for a 65-Year Old Couple With a 6% Lifestyle Goal, a 6% Minimum Needs Threshold, and a 2% Social Security Benefit As a Percentage of Retirement Date Assets (100,0) (0,100) (90,10) (90,10) (10,90) (80,20) (70,30) (20,80) (80,20) (60,40) (50,50) (40,60) (30,70) (70,30) (20,80) (10,90) 0 82 84 86 88 90 92 94 96 98 100 Percentage of Lifetime Spending Needs Which Are Satisfied (10th Percentile Outcome) (60,40) Frontier: (% Stocks, % Bonds) Frontier: (% Stocks, % Fixed SPIAs) Other Product Allocation Combinations (50,50) (40,60) (30,70) (0,100)
Thank you! Any Questions? Wade D. Pfau The American College McLean Asset Management instream Solutions wadepfau@gmail.com @WadePfau (Twitter) wpfau.blogspot.com (Retirement Researcher Blog)