Welcome back to another guest post. Dr. David Graham, over at FIPhysician has been on a roll. His spike in productivity has been the perfect “hedge” against my drop in productivity while traveling this summer, so when he offered me to write a follow-up on his very well-received guest post a few weeks ago, I was all for it. This current post is about adding a “glidepath” to your retirement portfolio and how and why this would change the success prospects over a 60-year retirement horizon. Over to you, Dr. Graham…
In my last post, I show a 4% Safe Withdrawal Rate (SWR) is actually NOT safe over 60-years (assumptions, assumptions). A more conservative 3.25% SWR does ok. On the other hand, if the asset allocation is increased from 60/40 to 90/10 stock to bond ratio, a 4% SWR thrives again. ERN advises, however, that a 90/10 portfolio sets you up for even more Sequence of Return Risk (SORR). SORR describes the long-term detrimental effects initial negative market returns have on overall portfolio success. Even if the stock market eventually recovers, selling part of your equity portfolio at rock-bottom prices can lead to premature failure of the withdrawal strategy.
What protects from SORR yet permits a higher SWR? A rising equity glidepath is one possibility. Let’s look at the details…
A glidepath primer (by Big ERN)
Obviously, I have written extensively on glidepaths. Two long posts in my SWR Series, Part 19 and Part 20. In a nutshell, in retirement you want to raise your equity share. Now that’s intriguing because the conventional wisdom has been that over your working years, you would reduce your equity share as you approach retirement. Shouldn’t you just continue the equity path down? No! The reason is Sequence Risk!
A rising equity glidepath means that you reduce (not eliminate, only reduce!) the necessity of selling equities while they are trading at (hopefully) temporarily depressed prices, say, during the Global Financial Crisis. But the glidepath keeps giving even after the worst of the crisis is over. In a way, the glidepath is actually even more useful after(!) the stock market reaches the trough, e.g., March 2009. A rising equity glidepath lets you keep riding the nice positive equity momentum (aka bull market) coming out of the crisis. With fixed stock/bond weights, you’d constantly rebalance your portfolio, i.e., sell equities that are rallying and buying bonds that are performing far worse. A rising equity glidepath reduces (not necessarily eliminates) this rebalancing that’s clearly a losing proposition during a bull market. You’d mostly sell bonds and let the equities ride! In summary, the reason why I think that this is so useful: The peak to trough in 2007-2009 was only 17 months (I know seemed like forever back then!), but the bull market so far has been going on for 10+ years and the glidepath keeps giving!
But now, back to Dr. Graham…
A Rising Equity Glidepath
Let’s look at combating SORR with a rising equity glidepath. Most glidepaths—those in target-date funds—decrease the stock percentage to or even throughout retirement. That seems inefficient because SORR is most problematic 5 years before and 10 years after retirement, so there is no reason to keep the stock percentage low after most (all?) sequence risk has passed.
A rising equity glidepath lowers stock percentage before retirement and ratchets it up thereafter. Can a rising equity glidepath increase your SWR? Let’s look at an early retiree who plans for a 60-year retirement and wants to protect that nest egg against running out of money. We will use the same basic assumptions from the post a few weeks ago…
A Reminder from the Last Post
As a reminder, see above a hypothetical scenario from my previous post with a 60/40 portfolio. In green, note a 4% SWR over 60 years. A Monte Carlo simulation (not displayed here) predicts a success rate of 18% and this portfolio expires after 44 years. In blue, a 3.25% SWR grows over time to reach $1.6M. Monte Carlo predicts a success rate of 44%.
Using a Rising Equity Glidepath
See the effect of a rising equity glidepath rather than a fixed 60/40 portfolio above. In green, a 4% SWR almost make it to 60 years. Monte Carlo odds are now higher at 29%. In blue, note the 3.25% SWR actually has a rising slope compared to the fading slope in figure 1. The portfolio size grows over time using a rising equity glidepath vs. a static 60/40 allocation. Monte Carlo odds are now 50%.
ERN: Isn’t this really fascinating? A small change to your passive asset allocation makes a huge difference. There’s no stock-picking, no market timing, just a passive asset allocation path, and the 4% Rule can last another decade and a half. It’s consistent with my findings from the SWR Series where I exclusively looked at the failsafe withdrawal rates, but it’s also nice to display the change in the retirement length for a given withdrawal rate.
Illustration of the 4% SWR with a Rising Equity Glidepath
Figure 3 demonstrates the percentage of portfolio withdrawn over time assuming a 4% SWR indexed for inflation. With a rising equity glidepath, the percentage of portfolio utilized every year stays under 5% for the first 15 years. Then, it slowly increases to critical levels after 50 years. Note that the 4% SWR fails in figure 2 at year 59.
Assumptions, Assumptions. Again!
For this scenario, ERN’s data is utilized to model a rising equity glidepath.
The portfolio transitions to 60/40 five years before retirement. After retirement, the portfolio rapidly increases to 90/10 over the next 10 years.
ERN concludes a rapid increase in stock allocation—over 10 years—performs better than increasing over 20 or 30 years. In addition, an aggressive portfolio performs better than less aggressive ones.
ERN: Again, the reason is that you want a glidepath that covers not just the bear market (often only 2 years or so, actually only 17 months in 2007-2009) but the bear market plus the subsequent bull market. You probably don’t need a glidepath over multiple business and market cycles, so 10 years sounds like the perfect sweet spot.
Instead of landing at 60/40 or even 100/0 after SORR, a 90/10 asset allocation is used from years 10 to 60 after retirement.
What about SORR?
Let’s look closely at sequence risk. We need to consider SORR given that 90/10 portfolios fail frequently due to negative market returns. What if we simulate SORR using actual returns from 2000-2010? After that first decade, assume that stocks return 9% nominal and bonds 4% (also nominal) for the purposes of this scenario (for a blended 8.5% return of a 90/10 portfolio).
SORR and Aggressive Portfolios
Above, we see the effect SORR has on 90/10 portfolios. In green, a 4% SWR rapidly extinguishes the portfolio after 25 years. Even a 3.25% SWR is no match for SORR in this setting, as seen in blue. The initial bad decade—and ongoing withdrawals from the portfolio—decimates almost half of the value. Over time, and despite decent assumed returns, 2% inflation catches up and extinguishes the portfolio after 55 years.
ERN: Even with the 8.5% blended portfolio return (0.9×9%+0.1×4%), you can’t sustain the 4% withdrawals plus inflation adjustments. That’s because the portfolio was so decimated during the two bear market. Recall, the 4% WR refers to the 4% relative to the initial capital. The effective withdrawal rate was above 8% at the bottom of the second recession! This is again the definition of SoRR! Some folks in the FIRE world always get this wrong; they think that it’s enough for the market to recover, but we have a much steeper hill to climb! The market has to recover the bear market drop, plus the withdrawals plus the inflation adjustments! That can take a long time! Or it may never happen and the portfolio runs out of money!
SORR and Rising Equity Glidepaths
Using the rising equity glidepath described above, a 4% SWR is still not safe. Seen in green, despite a rising equity glidepath, a 4% SWR survives 30 years but not 60 years.
Conversely, in blue, note the performance of a 3.5% SWR. A 3.25% SWR is too successful; instead, look at 3.5% SWR. The 3.5% SWR with a rising equity glidepath compounds after the initial bad decade and passes with flying colors.
A couple points to consider:
First, a rising equity glidepath improves performance assuming consistently low future returns. From my prior post, increasing a 60/40 portfolio to 90/10 improves the odds of success of a 4% SWR, but risks poor sequence returns.
Demonstrated here, both 4% and 3.25% SWRs are decimated by SORR. A rising equity glidepath, however, can help. It rescues a 3.5% SWR (more so 3.25% SWR), but not a 4% SWR.
FIRE vs. Traditional Retirement
Take care when discussing SORR and a rising equity glidepath. Traditional retirees—with 30 years left—are different than 60-year FIRE portfolios.
On the flip side, there is nothing conventional about FIRE. Proponents on the path to FIRE certainly are more financially literate than the average retiree. Critics of rising equity glidepaths point out it is difficult to get an 80-year old to invest 90% in stocks. Conversely, it is easy to talk a 40-year-old into aggressive investing, but try to talk that same 40-year-old down to 60% equities when they retire early!
Kitces mentions this subject. He starts with rising equity glidepaths but more recently recommends bond tents as volatility dampeners to protects against SORR. It may be that he changed his tune—going from rising equity to bond tents—so that he doesn’t have to sell old folks on stocks, rather sell younger folks on bonds.
Traditional retirement is a different animal. This review of rising equity glideslopes is not for them.
Practical Advice for a Soon-to-be Early Retiree
So, let’s say you will retire in 5 years at the age of 40. Now is the time to adjust your portfolio down to approximately 60/40.
This is especially true now, given high current stock market valuation.
In fact, ERN discusses that a rising equity glidepath is not useful during periods of low market valuations (e.g., low CAPE ratio). When valuations are high, however, (e.g., CAPE >20) there is a small benefit to rising equity glidepath—depending on the slope and beginning and ending allocation.
Then, once retired, ratchet stock allocation back up to 80% or higher once the risk of SORR has passed. ERN’s prescription—do this rapidly over 10 years—and, the higher stock allocation the better.
What is a safe withdrawal rate Over 60 Years?
So, what is a SWR for a 60-year retirement? ERN suggests less than 4% even with a rising equity glidepath. In truth, 3.25% is safer, but you might get to 3.5% if you protect your downside—SORR—and are aggressive again after the peril has passed.
Back to ERN for some final thoughts
Thanks again for taking the time to write this very important post. A glidepath is probably my personal favorite tool to cushion Sequence Risk. But wait? Aren’t we all supposed to be passive investors? Isn’t investing supposed to be simple? Well, saving for retirement is indeed simple (see JL Collins’ book), but as I outlined in my SWR Series Part 27, withdrawing money is a slightly more complicated mathematical and financial problem. There is some rationale for (ever so slightly) tinkering with your portfolio while withdrawing money in retirement. Apart from tailoring your SWR to equity valuations (see SWR Part 18) a glidepath is also recommended. It’s only slightly more “active” but it tends to raise your failsafe withdrawal rate by enough that people should really take notice. And by the way, is the glidepath really that active anyway? Remember, using fixed equity/bond weights would also potentially entail rebalancing your portfolio during the bear and bull market when equity and bond weights shift away from their target weights due to diverging returns! So, what’s really active and what’s passive here?
If a glidepath is so successful, then what’s the downside? Glad you asked! For full disclosure here are two (slight) caveats I can think of:
- The glidepath works like an insurance policy. If you indeed have a bear market right around your retirement date and then a subsequent bull market then you will certainly do better than the static allocation with a high equity weight. The downside is that when you don’t have a bear market but rather a continued bull market then – you guessed it – you will do worse than under the high static equity weight. But that’s when you don’t worry about running out of money. You can afford to do a little bit worse because that’s the scenario when the portfolio will likely grow beyond your wildest imaginations. Just like car insurance is “wasted” if you don’t have an accident. But even if car insurance has a negative expected value you still find it a good “investment.” It pays off when you need it the most and costs a little bit when it doesn’t hurt so much.
- The efficacy of the glidepath depends on how bonds perform during the bear market. If bonds actually rally during the bear market then the glidepath works best. We got accustomed to this negative correlation during the last few recessions, but keep in mind that this is not guaranteed. Case in point, the 1970s and early 80s. Stocks and bonds both dropped during the inflationary supply shock recessions. But even then a glidepath worked, just not as well as in a demand shock recession, provided that the bond portfolio drops less than the equity portfolio (which was the case even in that bad inflationary period).
Even with those two caveats, I’d still consider the glidepath a nice insurance policy against Sequence Risk!
Thanks for stopping by today! Please leave your comments and suggestions below!
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