The beginners guide to retirement part 5: More on sequence of returns

Running out of money in retirement is a real concern for most. As discussed in the previous post, sequence of returns can be a major determinant of whether our money will last our lifetime. If we are unlucky enough to retire just before a recession, or worse, a depression, then our chances of outliving our money drop substantially. Particularly if we are heavily invested in riskier asset classes such as shares.

The common advice is to reduce your exposure to shares and other risky assets as you age. The reason is we have less time to recover from our losses, and because we are no longer working, we cannot cover our losses with our work income any more. Losses become unrecoverable which is a real danger.

Many advisers suggest 100 minus age invested in shares as a asset allocation rule of thumb. For example, at age 60 you would have 40% in equities, with the rest in ‘safer’ assets. There are other variations of the rule of thumb, such as 110 or 120 minus your age. The higher numbers are due to lower bond returns and higher stock returns in recent years. As we discussed in the investing series though, chasing the current hot investments is one of the worst ways to go. 

In either case, the theory is for your stock allocation levels to reduce as you age.

I am here to provide the counter argument that your retirement funds are likely to last longer if you increase your share allocations as you age. 

Equity glidepaths

The most money that we tend to have in our lives is the moment we retire. Because we are at our wealthiest at this point, we are also at our most vulnerable. A large drop in the share market just after we retire can be disastrous for our portfolio longevity. We need to be especially prudent during these early retirement years in terms of investing.

There are 3 options for your share allocations.

1/. Decreasing your allocations to shares as you age (declining equity glidepath)

2/. Keeping your allocations the same as you age (static equity glidepath)

3/. Increasing your allocations to shares as you age (rising equity glidepath)

The key to your retirement account standing the test of time is minimising the downturns, whilst also having a high enough return to last up to 40 years. The only option that can achieve both is the rising equity glidepath.

Let’s consider each option under 4 different market conditions.

Market condition one - Markets perform well in early retirement, but poorly later in retirement.  In this scenario there is no sequence of returns risk. All three equity glidepaths will work, although the rising equity glidepath may perform worse than the other two.

Market condition two - Markets perform well throughout retirement.
Retirement will be successful regardless of your stock allocation strategy. Again, the rising equity glidepath strategy may perform worse than the other two options.

Market condition three – Markets perform poorly through retirement.
No allocation strategy will perform well in these conditions. At least a rising equity strategy would last a bit longer than the more aggressive asset allocation strategies though.

Market condition four – Markets perform poorly early in retirement, but recover later in retirement.
This is the scenario that we fear the most. Sequence of returns has its most powerful impact early in retirement and if we reduce the impact, our likelihood of outliving our money increases. This is the scenario that rising equity glidepath strategy works the best.

different equity glidepaths

Let’s assume you retired right on the 1987 recession at age 65 with an asset allocation of 60% NZ stocks and 40% bonds. You had the traditional declining equity strategy where your allocation to stocks declined 1% per year as you aged. By 2017 (age 95) your allocation would be 30% stocks and 70% bonds.

If you started with $700,000, withdrawing $25,000 per year, increasing each year with inflation (2.5% assumed). You have ended up running out of money by December 2004. Not even 20 years. 

What about the static equity option? 50% in stocks and 50% each year would have seen our $700,000 fund run out in 2005.

What if you had a rising equity glidepath strategy during the same 30-year period? Starting off with 30% stocks, and rising to 60% stocks over 30 years.  Your money would have lasted until 2008. An extra 3-4 years.

This is an extreme example, as this was the worst possible time in history to retire. A 48% share market drop in 1987, closely followed by a 40% drop in 1990.  It does prove however, that conventional wisdom may not always be the best for your situation. By starting off conservative, but increasing our allocation in shares as we age, we have ended up adding an extra 4 years to our retirement fund.

Let’s assume the same numbers but over a 30-year period that didn’t have an immediate crash the year we retired. Let’s say 1976 to 2006. With the same $700,000 invested we would end have ended up with:

Declining equity strategy – $1.56 million

Static equity strategy – $1.55 million

Increasing equity strategy - $878,000.

Final Thoughts

The rising equity portfolio strategy will not deliver the best result in all market conditions, but it will deliver the best result in the worst imaginable stock market conditions. A decline in the market as I retire is one of my fears and the rising equity strategy is a great way of minimising the risk of our portfolio running out of money. It may not be the best result, but it is also not the worst. I would rather eliminate the worst case than keep the potential for the best case as it helps me to sleep at night. Despite popular belief, the commonly used declining equity strategy does not deliver the best risk minimisation benefits.

Starting with a low equity portion and not increasing it as you age will not work either. Yes, you may get the safety of minimising sequence of returns risk, but you will not get the growth needed for your portfolio to last. Inflation will eat away at your low returns. Retirements can last 30 years or longer, so low risk portfolios will not work for most.

If you have either a very large amount saved, or are a very low spender, then each strategy will go further for you. Which strategy you go with, deeply depends on your risk levels, the amount of money you have, and your spending plans. There is no one size fits all.

The last two articles have discussed the impact of sequence of returns on our retirement, and ways to combat the effects. Next, we will discuss what retirement means in this day and age.

If you need help with your personal retirement planning, then get in touch today.

The information contained on this site is the opinion of the individual author(s) based on their personal opinions, observation, research, and years of experience. The information offered by this website is general education only and is not meant to be taken as individualised financial advice, legal advice, tax advice, or any other kind of advice. You can read more of my disclaimer here

Comment below. What are your strategies for your portfolio allocations in retirement? Will you own stocks? What percentage?