Financial planning industry thought leader Michael Kitces, CFPยฎ, CLUยฎ, ChFCยฎ, RHU, REBC, and professor of retirement income at the American College, Wade D. Pfau, Ph.D., CFA, penned a seminal work for the Journal of Financial Planning titled Reducing Retirement Risk with a Rising Equity Glide Path.
Their work and several tips can help with retirement income ideas for overvalued markets.
Well-read investors understand markets have been overvalued for nearly two decades. The short-term demand for stocks is driven by animal spirits, narratives, and the fear of missing out on opportunities. This does not mean markets crash in the long term, either.
There are cycles where markets churn for long periods.
A time correction can be frustrating and debilitating to wealth building. Time corrections are like overeating at Thanksgiving and sitting like a zombie for hours trying to work off a turkey coma.
Sometimes, markets go into a coma, too.
At RIA, we employ Lance Roberts’ CAPE-5, representing how markets operate today compared to Dr. Shiller’s CAPE-10. Markets appear more gluttonous than a King Henry VIII banquet and less like a family dinner.
Naturally, young investors care more about accumulation, which can be equally frustrating during lofty market valuation cycles. Young investors are generally willing to take additional portfolio risk since time is on their side.
However, I can argue that stock market risk doesn’t depend on age. Studies show that investment risk doesn’t dampen over time. An investor’s ability to compensate for the loss through additional savings can take the sting out of market risk. However, young or novice investors should know that market losses affect all market participants.
Now, back to prospective retirees.
I call this period “A “or accumulation.
Understandably, the closer someone is to retirement, the more critical a plan for lifetime inflation-adjusted income is. Reducing portfolio risk is also a priority. Retirees can’t afford to experience a significant market downturn in the early stages of retirement.
Financial professionals usually reduce a retiree’s equity exposure as retirement approaches and increase conservative selections such as fixed-income (bonds) and cash earmarked as reserves for withdrawals.
But is this the right thing to do?
The portfolio strategy appears to be effective on the surface. It’s appropriate to shield a retiree from future (or current) unfavorable stock market conditions and the time required to recover from an unfavorable sequence of market returns, especially in the face of periodic portfolio withdrawals.
Naturally, financial planners decrease equity exposure in retirement portfolios as life expectancies and time frames shorten. According to the research, this common tactic of employing a declining equity glide path can generate worse results than maintaining an ongoing, reduced stock allocation.
B is for boring.
Reducing a retiree’s equity exposure over time is a standard process. I classify the strategy as “B” or boring. Planners don’t want retirees to deal with the distress that can occur with portfolio volatility. Dull is appealing. Investment professionals also fear the repercussions of market losses on their businesses and client complaints.
The study results are counterintuitive to traditional thinking: To maximize sustainable income, raising equity exposure throughout retirement appears best. Portfolios that begin with a 20-40% allocation to stocks and increase to 60-80% generally increase retirement income sustainability and reduce the impact of shortfalls compared to static asset allocations.
The heart of Kitces and Pfau’s research is the โU”-shaped path for retirement income. Here’s how it works: Stocks are a more significant portfolio share through the accumulation/increasing human capital (earning power) stage, decrease at the beginning of retirement, and expand as a lifecycle strategy throughout the retirement period.
In other words, portfolios shouldn’t remain static throughout a dynamic retirement. No law or rule outlines that once a portfolio is rebalanced conservatively, it cannot expand or contract based on market conditions, spending, and lifestyle changes.
The โU” makes the most sense.
I have employed this U-shaped glide path since 2001. It’s a component of RIA’s current financial planning process.
Years ago, I reduced equity allocations based on the loss I felt clients could experience as they retired, given the lofty price/earnings valuations of stock markets during the dot-com boom. I also believed we were beginning a secular sideways market cycle reminiscent of 1966-1982.
In 2013, I increased equity allocations based on Federal Reserve intervention and attractive valuations.
When 2021 came along, our financial planning team adjusted forward-looking returns for every domestic asset class lower in all our planning programs. In 2022, we adjusted base inflation higher and rates of returns on domestic bonds higher.
How does RIA do it?
Currently, our financial planning team uses Lance’s CAPE-5, along with additional data from Research Affiliates. Based on our analysis, long-term stock returns will face headwinds, which means increased odds of lower forward-looking returns.
New retirees tempt fate by maintaining an aggressive portfolio stance. Investments must be closely monitored, and a sell discipline must be enforced once distributions begin. Investors should trim stocks during market strength to keep the cash bucket full and avoid forced liquidation of assets during periods of market weakness.
Consider the goal scoop!
Last year, we suggested several clients’ goal “scoop” and accelerate large purchases and home renovations earmarked for 2027. We moved goals forward based on their portfolio performances versus personal financial plan investment return benchmarks.
Although valuation metrics like Lance’s are far from perfect, we prefer to create plans based on realistic expectations. I feel better about the occasional underperformance in the face of sequence of returns risk, especially during the first decade of retirement.
The first 15 years matter.
โA” Kitces (2008) showed, in the case of a 30-year time horizon, the outcome of a withdrawal scenario is dictated almost entirely by the real returns of the portfolio for the first 15 years. If the returns are good, the retiree is so far ahead relative to the original goal that a subsequent bear market in the second half of retirement has little impact. Although final wealth may be highly volatile, the initial spending goal will not be threatened. By contrast, if the returns are bad in the first half of retirement, the portfolio is so stressed that the following good returns are crucial to carry the portfolio through to the end.โ
“The researchers placed an academic stamp of approval on what Iโve been doing for years: helping clients emotionally deal with stocks when they feel most vulnerable to the market and significant life transitions.
Once retirees have confidence in their retirement plans, many are amenable to adding equity exposure back into the allocation over time.
As a retiree, how do you deal with the findings?
Academic-based analysis is one thing; adding stocks to a portfolio during retirement when you feel vulnerable to household financial shocks is another.
A behavioral cheat sheet to follow the advice laid out by the researchers:
1) Decrease your stock exposure in the first year of retirement, and don’t fret missed opportunities. Focus on your overall emotional state, which may change as you move to a portfolio distribution mindset. You’ll experience the black hole, a period immediately after retirement where you feel displaced and not in control of your future. Distress dissipates as cash-flow mechanisms are implemented and new lifestyle habits emerge.
Special attention should be paid to monitoring household cash flow, budgeting, and the impact of establishing systematic, tax-effective portfolio withdrawals to recreate the paycheck in retirement.
In other words, focus on the issues you can control, especially for the first year in retirement. Pay special attention to the basics, and monitor progress regularly with a financial partner or an objective third party. If completed successfully, each step will build confidence and help you feel in control.
2) As you build confidence, increase equities when valuations are favorable. Depending on your circumstances, consider increasing equities beginning in year three. Consider your systematic withdrawal rate, coverage of household expenses, and portfolio performance. After two years of education and monitoring, I discovered that clients gained enough confidence to add stock exposure to their asset allocation programs.
3). Gain an understanding of how to maximize Social Security. Social Security is difficult to grasp. Ask your financial advisor to help you crunch the numbers to understand how to optimize benefits. It is essential to consider the coordination of benefits between two working spouses, especially when one is a lower wage earner.
A client example.
Recently, I increased stock exposure for a client after we increased total lifetime Social Security by postponing the triggering of benefits until age 70. Social Security is a lifetime, inflation-adjusted income. Consequently, a greater guaranteed income can allow a retiree to reduce portfolio withdrawal rates during market turbulence.
4) Life expectancyโthe conundrum. Nobody has a crystal ball when it comes to life expectancy. A decade ago, a client lamented how he’d be gone in five years. Today, he’s alive and well.
Ten years ago, we held 20% in equities. Today, his portfolio equity allocation is 50%. Those in good health and with long life expectancies in their families also have additional time to weather stock market volatility.
Want to estimate your life expectancy? Go through the 40 questions at www.livingto100.com, which uses the latest research and medical data to assess age. Clients with good health habits are amenable to adding equity exposure over the years. Their optimistic attitude and active lifestyle motivate them to believe living to 100 is achievable. Thus, achieving returns above inflation is vital to them.
5) Remain sensitive to your portfolio withdrawal rate. An unfortunate series of portfolio returns during the first half of retirement can result in a fast, unrecoverable wealth depletion in the second half. Again, complete a portfolio withdrawal rate checkup every two years to stay on track.
Total your cumulative net gains minus withdrawals. Move forward and increase your equity exposure if a surplus exists or more gains than withdrawals. Work with your financial adviser or planner to determine which equity asset classes require additional exposure.
Also, increasing equity risk to โmake up” for a lifestyle deficit is a big mistake. Before increasing stock exposure, a complete assessment is needed to review expenses, the current market environment, and future withdrawal rates.
The study’s research changes the current, staid perception of retiree portfolios.
Easing into stocks over time is a viable strategy for retirees. Portfolios do not need to remain static.
After all, your retirement is far from static.
