Investing for retirement is straightforward: place as much in equities as is comfortable, contribute regularly, keep costs low, and let time do the work. Investing during retirement is far more complex. Additional considerations include working out how much to withdraw from your pot, determining the time horizon, and deciding how flexibly to manage both the portfolio and withdrawal rate in response to stock market meltdowns.
A working paper entitled "Toward Determining the Optimal Investment Strategy for Retirement," by IESE Business School's Javier Estrada and Mark Kritzman of Windham Capital Management, sheds light on how retirement asset allocation is affected by stock market projections.
The authors employ a useful new measure they call the coverage ratio to gauge an investment strategy's success. The coverage ratio is a sound, reasonable way to score a retirement strategy's investment success and that it operates conservatively, by penalising failure more than rewarding success. Therefore, it does not arrive at high equity positions lightly.
For all analyses, the time horizon is fixed at 30 years. The withdrawal rate is similarly stable, at 4% in real terms. That is, the first year's payout is set at 4% of the initial investment, with each subsequent withdrawal matching the previous year's after being adjusted for inflation. The portfolios are rebalanced annually.
What would have worked in the past? The best-performing asset allocation for 12 out of 21 countries, since 1900, would have been 100% equities. This is based on looking at 86 periods of rolling 30-year total returns for equities and bonds from 21 countries.
Those figures seem high, obviously. The authors explain: "We suspect that our approach yields relatively aggressive strategies for two reasons. First, the equity-risk premium was relatively high in most markets in our sample; and second, we use a 30-year retirement period, and for such long investment horizons stocks have far more than not outperformed bonds."
As the authors note, though, investors cannot avail themselves of the past. They must instead experience the unknown, which could bring lower stock market profits, higher volatility, and/or less friendly performance sequences. It is useful to know the history but rash to rely solely upon it.
Higher Volatility Hits Equity Allocation
The authors therefore considered the unpleasantries. They fixed bond market performance at an average annual gain of 2% real return – the historic US norm – and an average standard deviation of 3%, which is optimistically low. Then they shaved the stock market's long-term average annual return of 6.4% after inflation. In addition, they boosted volatility. The US stock market's long-term annual standard deviation is 18%; the authors test figures that range up to 30%. Then they ran their simulations.
Both sets of changes, those for return and those for risk, had strong effects.
Halving the real stock market return, to 3% from a bit more than 6%, slashes the equity weighting at every level of volatility. At the calmest standard deviation evaluated, an annual average of 15%, the suggested equity position drops to 50% from 100%. For all other levels of volatility, it declines even further, as a percentage of the initial recommendation. If stocks don't make considerably more than bonds, they don't much help a portfolio.
You probably suspected as much, although it is useful to see the specific numbers to put scale to the intuition. What you may not have realised is that volatility damages stocks' attractiveness as much as does reduced total returns. Doubling volatility while keeping returns fixed has a similar effect to halving returns while keeping volatility fixed. The return and risk levers have equal strength.
This can come as a surprise, as returns are generally regarded as tangible, while risk is psychological. But that dichotomy does not hold for withdrawal strategies, wherein removing monies from a depleting portfolio can lead to a vicious circle, whereby the withdrawals become such a large percentage of portfolio assets that the investment enters a death spiral. It cannot replace with market appreciation what it loses while funding retirement benefits.
If history at least somewhat repeats itself, retirees who truly possess 30-year time horizons – one can sometimes be optimistic about such things – will thrive with equity heavy portfolios. However, if returns are substantially lower, or risk substantially higher, then a 50/50 allocation will perform better. Should both events occur, well … just own bonds!
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