Certainly no one wants to run out of money in retirement. But the majority of Americans—rich or poor—worry that they will.
GMO, the investment management firm co-founded by Jeremy Grantham, who is famed for forecasting market bubbles, addresses this critical planning issue in a new white paper with an unorthodox premise. GMO manages client assets of more than $112 billion.
“Investing for Retirement: The Defined Contribution Challenge” is written by Ben Inker, co-head of GMO’s asset allocation team, and Martin Tarlie, a global equity team quantitative researcher at GMO. They argue that dynamic asset allocation—a strategy of moving assets around in a portfolio—is essential to minimizing the chances of outliving one’s money.
Decisions in the post-retirement phase, Inker and Tarlie write, are perhaps even more important than those made in the accumulation phase.
To minimize a shortfall in the golden years, they advocate a holistic, wealth-focused—not return-focused—approach based on changes in investor needs and asset values.
Dynamic asset allocation, affording customized portfolios, can apply to any type of retirement account whether a 401(k) or one managed by a financial advisor.
Inker, a certified financial analyst and member of GMO’s board of directors, has been with the firm since 1992, when he graduated from Yale University with a B.A. in economics. He has held a variety of posts, including analyst for the quantitative equity and asset allocation teams and portfolio manager of several equity and asset allocation portfolios.
Research spoke with the Boston-based Inker by phone to delve more deeply into dynamic allocation and discover his forecasts for bulls, bears and bubbles.
First, are we near a bubble?
If one wants to define a bubble as two standard deviations [above trend], we’re within shooting distance. But we’re not there yet. However, it’s a materially overvalued market, and you want to react. One of the important lessons is: Don’t wait for something to move two standard deviations before you react at all. So today might not yet be a bubble; but it’s still a situation where stock valuations are high, and therefore expected returns are relatively low.
Folks seem to have the feeling that there’s an ax hanging over their heads, worrying: When is this bull market going to end?
I wish they would get away from that. I haven’t the faintest idea when it will end. But if you focus on making sure you’re participating up until the very end, you run a risk of holding on as the market goes over the cliff and not knowing what to do. It makes a lot more sense to look at the stocks that are priced to deliver and the kinds of returns you can expect out of them at these valuations. The higher the number, the more you should own. The lower, the less you should own.
What, then, is your outlook for this year?
We don’t expect a lot from the U.S. stock market. When stocks are expensive, as they are now, they usually don’t go up a lot. Our best guess is single-digit returns. I don’t know if that single digit will be a positive one or a negative one. Valuations aren’t so extreme that it’s a market that needs to fall apart under its own weight. But there’s no particular reason to expect that you’re going to get good returns. If we happen to have them, it just means that next year will be much worse.
Now let’s talk about the positive idea of people not outliving their money. Why did you write this paper about retirement investing?
We consider dynamic allocation a critical tool to get people better outcomes in retirement. Changing your allocation with changing valuations can increase returns and crucially decrease risk. Dynamic asset allocation comes not just from running away from equities when they’re so overvalued that they’re worse than bonds but also moving your portfolio around when the return-to-risk is lower or higher.
But if an investor foresees that they’ll run out of money, why not just change the allocation to be more aggressively invested?
In that situation, the appropriate response for an advisor is not “and therefore you have to get more aggressive.” It should be “and therefore you need to save more.” If you’re one day away from retirement and have only half the money you were hoping to have, it doesn’t make sense to go to the casino and put it all on risk.
What do you mean specifically by “save more”?
Putting more money into retirement assets. Make sure you’re maxing out your 401(k) or IRA. If you’ve got the ability, make sure you’re putting money in a Roth IRA. Figure out how to get more money that will be compounding on your way to retirement.
But why wouldn’t you want to get more aggressive by investing in equities?
If you know you’re going to need $30,000 a year, in inflation-adjusted terms, from an account for 30 years after you retire, how do you get there? The way you want to worry about that is not: “What are the odds of my getting there?” It is: “How catastrophic is my expected shortfall?” If a person who has half as much money as they planned at one-day-to-retirement, they’ve got a 50-50 shot. But they’ve also got a 50-50 shot of being utterly destitute in retirement. It doesn’t make sense to be more aggressive if you don’t have enough money.
What about the fact that, traditionally, stocks have produced better returns than bonds?
Don’t get me wrong—you need to have stocks in your portfolio well after retirement because if you’re 75 and have a life expectancy of 90, you’ve still got to earn returns over 15 years and protect yourself against inflation. Equities do that much better than bonds. So you want to be reasonably aggressive, but that aggressiveness is associated with: “What money do I need? And when do I need it?”—rather than: “Well, I haven’t saved enough, so I’ve got to roll the dice.”
You write that far too little attention is paid to investing after folks retire.
With a lot of 401(k)s or other retirement plans, once you retire, you’re either on your own or in the hands of an advisor. The problem is people aren’t necessarily well positioned to figure out who’s a good advisor and who isn’t.
And many people think they can do their own their investing.
Yes. Investing isn’t brain surgery—you don’t need 17 years of professional training to do it. However, when people make their own investment decisions, an awful lot of them make really, really bad ones. Schools don’t teach this stuff; they don’t teach it in the workplace. So people aren’t equipped with the tools for it. And the emotional aspect [of investing] absolutely enters into it too.
Do advisors do a much better job?
The problem we see in a lot of the conversations advisors have with clients is that they want to make saving for retirement a psychological issue. They talk about how their psychological profile differs from that of other people, and therefore their willingness to take risk differs from the next guy.
What’s the matter with that?
It’s not a particularly useful way of thinking about the problem. The reality is that if your client is risk-averse, the response that leads to better outcomes in retirement is not: “Put more money in bonds and less in stocks.” It’s: “Save more.” The question is: “How likely is that portfolio going to give you the wealth you need to retire on to support the consumption you want?” That has nothing to do with psychological risk-aversion. But it’s got a ton to do with: “How long do I have before drawdowns really matter?”
Are you advocating just rebalancing during retirement?
We go a step further. Take this, for example: “Wow! Stocks just fell 10%. That probably means they’re 9% or l0% cheaper. A 50:50 allocation was the right place to be before; but now maybe it should be 53:47 or 55:45.” Dynamic allocation is: Sell what’s been doing well; buy what’s been doing badly. Move your portfolio not just back to a static allocation, but move it beyond that so you’re tilting it toward the better opportunities at any given point.
When is the best time to employ dynamic allocation?
Even if you’ve got only a couple of years to retirement, having the right asset allocation is a big deal. We would argue that today your allocation should probably be less stock-heavy than normal—certainly less heavy in U.S. stocks because they’re not priced to give anything like a normal return, and they’re risky and volatile. They can still do nasty things to your portfolio. Therefore, you need to get paid for taking that risk and for the ugliness that equities embody. The less you’re getting paid for that ugliness, the less [equities] you should own. This is true for a 63-year-old or a 43-year-old.
What, then, are the opportunities in today’s market?
If you’re going to buy equities, we think the ones to buy, generally, are outside the U.S. European value stocks and emerging [markets] stocks look significantly better than U.S. stocks. But if you’re going to own U.S. stocks, the ones to own are the big, stable, high-quality blue chips rather than small cap, which to us look dangerously overpriced. There’s nothing cheap enough, though, to pound the table and say, “Wow! This is going to be a wonderful return!”
What about bonds?
On the fixed-income side, there isn’t a lot you can do. But Treasury Inflation-Protected Securities—TIPS—make a fair bit of sense because in retirement, what you care about is real purchase income, and bonds don’t protect against inflation.
What good or ill has the Federal Reserve’s policy of quantitative easing brought to pre-retirees and retirees?
The biggest problem for investors is that, by pushing down the yields so much, it pushed down the yields on bonds, which retirees need. And it pushed up the prices of stocks, which is the other way retirees can generate returns.
Anything upbeat about that?
The good news about bond yields going down and bond prices going up is that you got better returns over the last five years. So you’re in better shape if you’d done all your savings before five years ago. If you’re five years into retirement, your portfolio has probably gone up more than you were expecting. The bad news is that the prospective returns are worse.
Any other thoughts about equities?
Historically, whenever valuations have been as high as they are now, the return on stocks has been pretty low. We have no reason to believe that this time will be any different. The Federal Reserve has said that a goal of quantitative easing was to cause asset prices to go up—and they did. So if they’re going to take credit for that, they’ve got to take the blame that this means prospective returns are worse.
What else should be kept in mind when allocating retirement portfolios?
At the margin, you probably want to own fewer stocks than normal and really make sure that your stock allocation is biased toward those few areas where you’re getting paid for taking stock risk. My advice is to try to up your savings a little. But just because you’ve retired, that doesn’t mean you should be putting all your money in bonds. Again, a 75-year-old needs to protect against inflation. And very low-risk [products], like bonds and CDs, don’t do that very well.
Are you next in line to succeed Jeremy Grantham? I imagine that he has a succession plan in place.
Jeremy Grantham is an utterly unique kind of talent in the investment world, and I’m not attempting to be him. As a firm, we’re not attempting to recreate him. We’re attempting to make use of him for as long as he’s willing to come to work. We’re attempting to make sure that we’re doing whatever we can to manage our clients’ money well while he’s here and the day he can no longer come to work.