Review & Outlook

Our take on the investing, financial, & economic themes of the day

Rethinking Retirement Asset Allocation

28 January, 2014 by Ben O'Brien in Commentary

In some recent posts on target date funds we questioned the wisdom of an automatic “glide path” that continues to increase the amount of fixed income in a portfolio over time even after an investor reaches retirement. We prefer a more dynamic, customized asset allocation. A recent recent Wall Street Journal article entitled “What You Know About Retirement Investing Is Wrong” cited a financial planning study that backed up this view. The study confirms the first part of the usual approach, which is to reduce equity exposure at the time of retirement. From there, however, the study shows that the better approach is to allow the equity allocation to gradually grow again rather than continuing to lower the equity ratio as a target date fund would. The WSJ writes:

The report finds that those who take the opposite approach—by reducing equity exposure right after retirement and then gradually raising it over time—are likely to make their money last longer. According to the research, those who start retirement with 20% to 30% in stocks and end up with 50% to 70% in stocks can withdraw 4% of their portfolio per year and give themselves annual raises to compensate for inflation over 30 years, even in the worst market scenarios. (The authors examined 10,000 simulations and assumed average annual returns of 6.5% for stocks and 2.4% for bonds.)

In contrast, those who keep 60% in stocks throughout retirement or who taper to a 30% equity allocation from 60% are likely to run out of money after 28 years in the 5% of worst-case scenarios, says co-author Wade Pfau, a professor of retirement income at the American College of Financial Services in Bryn Mawr, Pa.”

The so-called “U-shaped” asset allocation, lowering equities as the investor reaches retirement but then gradually allowing them to increase protects the investors when they are most vulnerable to a market downturn, which is at the beginning of retirement.  When retirees first begin living off their investment savings, it’s helpful for planning purposes to have a stable retirement income base.  As retirees gain experience living within their planned retirement allowance, they become more adept at planning large expenses during good years in the market and choosing to live a little more frugally when the market does not cooperate.  And if a downturn comes in the second half of retirement, it is less damaging because the investor has already benefited from years of growth for the first half of retirement.