Hey guys, Mike Frontera here with Retirement Theory. All right, so what am I talking about? Have I gone completely crazy? Why would we be increasing stock exposure in retirement? I’ve always heard you are supposed to decrease stock exposure, make your portfolio more conservative as time goes on. There’s that old adage, you take 110-your age and that’s how much you should have in stocks. So, what is this notion of the opposite, increasing stock exposure as time goes on?
So actually there’s some really good research behind it from these two prominent researchers: Michael Kitces and Wade Pfau had this hypothesis that a rising equity glide path in retirement actually leads to more successful retirement outcomes versus one that is decreasing.
So, it’s not really intuitive as far as why we would want to increase our stock exposure as we go through retirement, but as we look at the data and the evidence, it actually starts to make sense. So yes, as we approach retirement age, in general, equity exposure, or stock exposure, should be decreasing. We do want our portfolios typically to become more conservative as we approach retirement. And the reason is something that’s called, “Sequence of Returns Risk”.
Ok, so lets first go back and explain what Sequence of Returns Risk means. So basically, it means that the order of the returns that you experience in your investment is critically important when it comes time to draw off an income. And now the order of returns when you’re accumulating doesn’t really matter. So, what I’ve got here is two portfolios that we’re hypothetically investing in the S&P 500, which obviously you can’t do. You can’t invest directly in an index. It’s just for illustrative purposes. And what I am looking at is a 20-year period starting in 2000. And what I’ve got in portfolio B is that same 20 years with just the years and calendar year returns in reverse. And what you’ll notice is if we’re just saving that $500,000, it doesn’t matter what order the returns come in, we end up at the exact same place no matter what order the returns are in. However, when it comes to taking withdrawals from the portfolio, you can see now with the two portfolios, same returns over the same 20 years, the order in which you get those returns is dramatically important.
And so it goes back to this concept of that when you get to the point that you are changing over from accumulating assets to creating an income stream for yourself in retirement. Those early returns, in particular, are of vast importance. So, the point that Sequence of Returns is important in the beginning is pretty intuitive. It basically it’s that not just negative returns, but also withdrawing after those negative returns doesn’t leave a large enough base in your portfolio to subsequently rebound when the market ultimately does. So it’s those withdrawals and especially in early retirement because we still have a lot of years that we still have to cover for.
So the idea then is we get back to a rising level of stocks in our portfolio comes from the fact that we have to fund for less and less years as time goes on. And so that risk, that Sequence of Returns Risk, becomes less and less important. And then a second point to that is that if we maintain a very small or a low stock exposure within our portfolio throughout retirement, we also have more vulnerability to that longevity risk that ultimately, we don’t have enough growth to sustain for a longer period of time versus having increasing stock exposure.
Ok, so what happens if stocks are actually performing well when I get into retirement? Well, that’s great. You can always reevaluate your strategy. You don’t have to stick to anything for any length of time. So if it doesn’t make sense to increase your stock exposure at that point, that’s great. But keep in mind you also have now decreased your average withdrawal percentage because your portfolio has grown, in so, your risk capacity, your ability to take on risk, has increased and so if you want to increase stock exposure at that point, it maybe more appropriate to do so.
So, have questions for me? let me know? Come visit me at www.retirementtheory.com or send me an email at Mike@retirementtheory.com. Did you click subscribe on this video or follow me on Facebook? I think that you should. You’ll continue to see videos like these on everything retirement planning. Once again, thanks again. See you next time.
- Pfau, Wade and Kitces, Michael. "Reducing Retirement Risk with a Rising Equity Glidepath." https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2324930
- Kitces, Michael and Pfau, Wade. “Retirement Risk, Rising Equity Glide Paths, and Valuation-Based Asset Allocation” https://www.financialplanningassociation.org/article/journal/MAR15-retirement-risk-rising-equity-glide-paths-and-valuation-based-asset
- Crazy Eddie: https://www.youtube.com/watch?v=Ml6S2yiuSWE