Dangers of De-risking Portfolios in Retirement: FinaMetrica’s Resnik

Paul Resnik shows that there are good arguments for actually increasing equity asset exposure around retirement

The common view that retirees need to decrease exposure to risky assets as age increases may not be entirely true.

According to research from Paul Resnik of FinaMetrica, the fear of sequence risk drives investors to take equity and risky asset exposures out of their retirement portfolios — and unnecessarily so, the research also finds.

“The history says that we’ve de-risked portfolios thinking that we’ve been good to clients — and we haven’t!” Resnik told ThinkAdvisor.

Resnik said that some of his research on sequence of returns risk shows how many of the standard approaches to investment in retirement plans may be flawed.

Sequence risk is the fear that a series of bad returns in the early stages of retirement drawdown will significantly diminish capital values such that the portfolio is incapable of recovery, can't support future drawdowns and will not meet its investor's longer term needs.

To avoid this phenomenon, investors take equity and risky asset exposures out of their retirement portfolios.

What Resnik finds, though, is that reducing equity exposure has not changed the poor and worst returns in any meaningful way but would probably have had a negative impact on the average, good and best returns.

Through analysis of historical data from over the last 40 years  from three countries — U.K., U.S. and Australia — Resnik  compared 40% equities to 80% equities in a portfolio, also taking into account home country bias.

The rolling 10-year real return for a 40% equities portfolio over the past 40-plus years was 5.5% per annum in the UK, 5.5% in the U.S. and 5.9% in Australia.

An 80% equities portfolio in the UK would have delivered 0.9% per annum more at 6.4% per annum; in the US it would have been 1.4% more at 6.9%; and 1.2% more in Australia at 7.1%.

From there, Resnik examined how sequence of returns risk factors into a less risky (40% equities) and more risky (80% equities) portfolio.

From both the 40% equities and 80% equities portfolios, Resnik examined a draw down $3,000, $5,000 and $7,000 per annum, adjusted for inflation each year from a $100,000 portfolio. There is no allowance for fees, taxes or other frictions, which can amount to 200 basis points (2%) or more each year.

Resnik then reinterpreted the data to show what might happen in future years, assuming income withdrawal continues to determine how many years of future payments that retiree would have.

First, looking at the 40% portfolio - after 10 years an investor withdrawing $3,000 per annum had on average about 45 more years’ payments; in the poor case, they had 23 more years; and in the very worst case roughly 17 more years.

After 10 years an investor withdrawing $7,000 per annum had on average 11.6 more years’ payments; in the poor case 3 years; and in the very worst case 2.1 more years.

How does this compare to the client who took on the additional 40% risky asset exposure and ran with an 80% growth asset portfolio?

Looking at the 80% portfolio - after 10 years an investor withdrawing $3,000 per annum had on average about 54 more years’ payments; in the poor case , they had 19.5 more years; and in the very worst case roughly 16 more years.

After 10 years an investor withdrawing $7,000 per annum had on average 14.6 more years’ payments; in the poor case 2.4 years; and in the very worst case 1.3 more years.

Resnik, at first, doubted these conclusions.

“We looked at these numbers. This doesn’t make sense, does it? You’ve taken less risk but you’ve got the same outcome. Well clearly this is an anomaly. There’s a flaw in the data. This is not consistent with what anybody would have expected,” he told ThinkAdvisor.

While these are the U.S. findings, Resnik found no significant differences in future year payments for portfolios across the three countries in the poor and worst cases.

Of the poor and worst returns, investors in the 80% exposure were not significantly worse off than those who had taken lower exposure. For those with 40% exposure, in terms of the poor and worst returns, investors did not necessarily have a lower return for lower growth asset exposure. 

Why did those with higher exposure not have much worse poor and worst outcomes?

As Resnik explains in his report, “this is because over any 10-year period markets have generally recovered from their falls, and portfolios with higher exposure to growth assets participate more fully in that recovery. In other words, the added return from the higher equity exposure paid for the additional non-crystallised loss.”

At its simplest level, Resnik said the factor that affected the nature of the outcome of his research was not the asset allocation. Rather, he said what mattered was how the investor managed his cash flow.

“It was actually how you managed your cash flow, how you managed your withdrawals,” he told ThinkAdvisor. “Which is no different than common sense. No different than what you learn in school when you’re saving for a bicycle – the fastest way you get to it is to spend less and put more money in. It’s all about your relationship to spending than saving. It’s not to do with the asset allocation. That’s what the data shows.”

Not everyone’s jumping on the bandwagon, just yet.

Michael Kitces, who has done his own research on sequence risk, questioned the methodology behind Resnik’s research.

“Their research basically only looks at times that haven’t had really bad market declines and concluded that it’s OK to own more equity,” Kitces told ThinkAdvisor. Adding, “They went 40 years back – so they didn’t even get the worst periods in the U.S. which was retiring in the 1960s or retiring in the late 1920s – all of which were the worst time periods.”

According to Kitces, there is a fundamental challenge with looking at sequence risk analysis that looks only at a recent time period.

“The research on sequence risk comes from environments like: What happens if you retire and it turns out it’s the next Great Depression like 1929?” Kitces said. “Well, [FinaMetrica] didn’t test that time period … That’s a problem, right? Because you're not including the most problematic time period that actually originated the whole approach [of sequence risk] in the first place.”

Kitces suspects that had FinaMetrica rerun the numbers going further back they may have come up with a different conclusion.

“If you exclude the time period where markets fell 85% of course it looks better to own stocks,” Kitces said.

Resnik is quick to point at that while this is what the historical data show, it’s not necessarily a foreshadowing.

“Over the last 45 years, this is what’s happened. It’s consistent in three countries. Does that mean over the next umpteen years it will be the same thing?” he told ThinkAdvisor. “I don’t know! I’m a historian. The numbers do the talking.

Kitces does agree that taking equities and risky assets completely out of the equation as an investor approaches retirement isn’t the best solution.

Rather, Kitces’ suggestion is what some have dubbed the “rising equity glide path idea.”

“You don’t take all of your equities off the table as you approach retirement, you just get more conservative at the beginning of retirement and you then you actually add them back later,” Kitces told ThinkAdvisor.

The idea is to get conservative at the beginning of retirement, when a market decline would be the most destructive to a client’s assets.

“The problem isn’t because they get conservative at the beginning of retirement, the problem is because they keep getting conservative all the way through retirement and that’s what creates the problem,” Kitces said.

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