Traditional wisdom dictates that a client’s allocation to equities should decline as he or she gets older, but in a session at the IMCA annual conference on Monday, Michael Kitces asked if that was more tradition than actual wisdom.
Kitces said there were two fundamental questions clients asked about safe withdrawal rates: how much they can spend without worrying about the market, and how much they need to save to spend a certain amount.
The average withdrawal rate is 6.5%, but as Kitces pointed out, using the average rate will by definition fail 50% of the time. You shouldn’t care about the average as much as the lows, he said: “How bad does it get if your timing is bad?”
Kitces pointed to several historical market events that led to the commonly accepted 4% safe withdrawal rate: the credit crash of 1907, the market crash that led to the Great Depression in 1929 and the dramatic “stagflation” of the 1970s. A retiree during those events could have safely withdrawn 4%, thus the 4% rule.
However, following those events, markets returned to similar levels each time, suggesting that the withdrawal rate just has to be low enough for retirees to get through the crisis before the markets return to normal, Kitces said.
Kitces suggested a strategy to create retirement income: at retirement, annuitize the bond portion — or part of it — of the client’s portfolio. The annuity provides income for the near term, while the rest of the portfolio continues to grow.
Under this strategy, a client’s equity allocation increases, but Kitces found that portfolios with higher equity allocations fared better than those with an allocation that decreased over time. He examined the effect of several factors: mortality credits in the annuity, sequence risk and rising equities.
He found that mortality credits actually hurt the client until he or she had been retired for at least 30 years, suggesting that the benefit was not from the annuity, but from the great allocation to equities.
He said that there was already 20 years of research that shows the traditional decreasing equities allocation is not as good as many people think it is. A 1996 paper by William Bengen found that declining equity reduces the maximum safe withdrawal rate, but at a 1% decline per year, it may be a reasonable tradeoff if it makes the client more comfortable.
A 2007 paper by David Blanchett tested more than 40 different glide paths and found that a static equity allocation did at least as well if not better than a declining equity glide path.
Kitces noted that neither of these papers tested a rising equity glide path, so he conducted his own study. He tested 121 glide paths with a 4% and a 5% withdrawal rate to measure the probability and magnitude of failure.