This action might not be possible to undo. Are you sure you want to continue?
By Joe Tomlinson August 20, 2013 Following the 2008 financial crisis, target-date funds (TDFs) were criticized for exposing investors nearing retirement to excessive equity allocations. Were those criticisms justified? How well do TDFs stack up against the venerable strategy of matching one’s bond allocation to one’s age? My research has yielded surprising answers to those questions and to the proper role of single-premium immediate annuities (SPIAs) alongside TDFs. TDFs are grabbing a bigger share of retirement savings portfolios and getting more attention from advisors. As clients approach retirement, they will need advice about what to do after retiring – whether to stay with the same TDFs or change strategies. Part of the evaluation will involve examining stock allocations and post-retirement glide paths. Advisors may also recommend investments to supplement TDFs such as annuities. I'll use an example to show how allocations and glide paths can affect retirement outcomes, and I’ll show how outcomes can be improved by adding SPIAs to the investment mix. Background TDFs have become hugely popular since being named a qualified default investment alternative for 401(k) plans under the Pension Protection Act of 2006. Savings in these funds topped $500 billion in 2013's first quarter, and the rapid growth continues. But since the stock market losses of 2008, the growth has been accompanied by controversy. For TDFs with a target maturity date of 2010 (two years from retirement as of 2008), losses ranged from 3.5% to 41.3% in 2008, according to Ibbotson®. This was devastating for many workers preparing for retirement. Congress and Government Accountability Office launched investigations. Everyone involved began to learn about stock-allocation glide paths and the difference between "to" funds (which gradually reduce stock allocations up to a target retirement date) and "through" funds (which continue to reduce stocks over the full course of retirement). It became apparent that, even within the "to" and "through" categories, various TDFs were using widely different stock allocations. This commotion awakened clients and advisors to the importance of allocation strategies and glide paths. These fund characteristics are critical as clients approach retirement.
-1© Copyright 2013, Advisor Perspectives, Inc. All rights reserved.
and I subtracted 0. I also assumed variable longevity based on a life expectancy of 22 years to age 87.20% for expenses. She wishes to take withdrawals of $20. Advisor Perspectives.90% for stocks and 1. My expense assumption is representative of low-cost target date funds such as those offered by Vanguard. and holding this allocation for life. particularly for active management strategies. I also compared these allocations to a rule of thumb called "your age in bonds. aggressive allocation: 65%/35% stocks/bonds at age 65. I used a Monte Carlo projection method based on average returns after inflation of 5. These withdrawals and her Social Security will be needed for living expenses. I developed the following four hypothetical fund options: Declining glide path. Inc. Level glide path. Declining glide path. This analysis focuses on stock allocations and glide paths only. aggressive allocation – 50%/50% stocks/bonds at age 65.00% for bonds.An example I'll base this analysis on a 65-year-old female. . A fuller evaluation could also compare expense levels for individual TDFs--most charge more than I have assumed. Level glide path. Based on information from Morningstar® on the ranges of stock allocations and glide paths offered in TDFs.000 in the first year of retirement with inflation increases each year thereafter – the classic 4% inflation-adjusted withdrawal rate. declining linearly to 40/60 over 15 years. just retired. she can choose between funds with declining stock allocations over the course of retirement and funds that hold the stock allocation level. with $500. To generate estimated retirement outcomes. and her primary focus will be retirement security If the client decides to continue investing in a TDF.000 in a TDF. declining linearly to 20/80 over 15 years. and holding this allocation for life." in which a client's portfolio holds 65% bonds at age 65 and increases the bond percentage by 1% each year thereafter. conservative allocation – 25%/75% stocks/bonds at age 65. I will bring in SPIAs later. Other considerations could include the potential value added from factors such as stock -2© Copyright 2013. All rights reserved. These returns are more conservative than historical averages reflecting the reasoning I described in a January 2013 Advisor Perspectives article. conservative allocation – 30%/70% stocks/bonds at age 65.
which is the standard often used in retirement planning research.5% -$73. As a failure measure. For a failure measure that takes both probability and magnitude into account. have modified this rule to include the present value of Social Security as a bond-like investment.000 Source: Author's estimates 30% --> 20% Level 50% Level 25% Age in bonds $223. Average bequests are higher than medians. -3© Copyright 2013. which provides a way to gauge the magnitude of failure. -$13.4% -$72. I multiply the average failure by the probability of failure. Some investment professionals.000 $193.000 Median bequest $296. was conceived in an era of higher bond yields.500 17.000 17.000 Failure probability 14.000 Avg.600 12. Results for different glide paths 65% --> Glide path 40% Average bequest $392. so I rely more on median bequests for comparison. Comparison of results I show projected bequests as positive measures and depleted savings during retirement as negative measures. The rule of thumb that stock allocations should decline with age also doesn't hold up relative to the other strategies.000 $225. tactical allocation shifts and the inclusion of alternative investments like commodities.300 17.000 $295.000 -$10. Much of the complaining about 2008 TDF performance was that funds close to target retirement dates were too heavily invested in stocks.000 -$12.800 There's a bit of irony in these results.7% -$82. That rule of thumb. Inc. times Prob.1% Average failure -$92. I also show the average failure for those cases where the client depletes savings.000 $192.000 -$12. All rights reserved. particularly for heavy stock allocations.000 $194. But these projections show that aggressive stock allocations perform better over the full course of retirement than conservative ones do. It represents the probability of depleting one’s savings while still alive.000 $227. which also argues for more aggressive stock allocations. I show the probability of failure.selection. including Jack Bogle.2% -$72. Advisor Perspectives. .000 -$12. Such bequest amounts could also be used to support discretionary spending during retirement.000 $393. however.
-4© Copyright 2013. Advisor Perspectives. However.515 -$10. Bengen based his assumptions on historical returns and demonstrated nearzero failure rates.300 Not surprisingly. -$10.000 $330. I had conjectured that.700 14. I start with the best outcome from the previous chart (level 50%) and try some variations.400 Level 40% 75% >60% $629. perhaps increasing allocations would work best.000 $108. Additional tests Can one achieve even better retirement outcomes by using even higher stock allocations? In this chart. . The rightmost column shows an unusual glide path that begins at 40% at age 65 and increases to 60% over the next 22 years (life expectancy). All rights reserved.000 $380.000 Avg.000 Median bequest $295.000 -$10. but I would not recommend using them as prescriptions for actual clients.2% -$95. these results confirm financial planner Bill Bengen’s research on the retirement withdrawals in the early 1990s. Going in the other direction to 40% stocks reduces bequests but barely improves the failure measures. and the negative outcomes deteriorate. Inc.000 $472. times Prob.000 Failure probability 12.7% 13.500 Source: Author's estimates -$76. client characteristics and withdrawal rate.0% -$82. In some ways.000 $377. Outside the glide paths – comparison of results Level Level Level Glide path 50% 40% 60% Average bequest $393.000 $254.000 13.000 -$12.000 $283. Overall. whereas my study assumes lower investment returns and demonstrates failure rates above 10% for a 4% withdrawal rate.The glide path that achieves the best balance between positive and negative measures is the level 50% stock allocation. My conjecture was incorrect. They provide indications of what works best. Bengen showed that level stock allocations in the 50%-to-75% range produced the best retirement outcomes. the average stock allocation during retirement has a much bigger impact on performance than whether the glide path rises or falls.700 -$15.4% Average failure -$82.000 $316.6% 13. These results depend on the combination of assumptions. if level allocations worked better than declining allocations. and the 50% level was the sweet spot for this example. the average and median bequests increase with higher stock allocations.
000 Median bequest $295.000 $249.8% Average failure -$82. because this lowers the withdrawal rate on remaining assets. Strategy 2 attempts to correct the overall allocation back to 50%/50% (67% of $375.000 (25% of savings) in an inflation-adjusted SPIA and leaving the remaining $375. SPIAs are much like bond investments – adding a 25% SPIA allocation and leaving remaining $375. times Prob.000 $321. which translates to a withdrawal rate of 3.77%.400 Source: Author's estimates Strategy 2 Level 67% w/25% SPIAs $448.963 annually. The two strategies differ in the stock/bond allocations on the remaining $375.5%. Advisor Perspectives.000 10. In this example.000 $303. so it will provide an inflation-adjusted lifetime income of $5.000. Both SPIA strategies involve investing $125.5% -$65. Bringing in SPIAs – effect on outcomes Base Strategy case 1 Level 50% w/ Level 25% SPIAs Glide path 50% Average bequest $393.Can SPIAs help? This chart repeats the level 50% outcomes as a base case and shows outcomes for two different strategies in which SPIAs are introduced as an investment alternative along with stocks and bonds. All rights reserved. I chose 25% for this example based on what might be practical to recommend to a client.000 -$6.000 invested 50%/50% lowers the initial stock allocation on the total $500. The SPIA has a payout rate of 4.000 -$55.037/$375. Inc. .74% ($14. -$10. For such cases.000 to be invested in stocks and bonds.037 to come from withdrawals on the remaining $375. based on rates from Income Solutions®.000 = -5© Copyright 2013.800 Focusing first on failure outcomes. we see a bequest reduction compared to the base case.000 Avg.000 Failure probability 12.963 of inflation-adjusted income will come from the SPIA. failure outcomes could be improved by further raising the SPIA allocation.000. leaving $14.000) on those remaining assets. $5.000 to 37.500 -$5. SPIAs have the biggest impact in cases where the SPIA payout rate is significantly higher than the withdrawal rate. both SPIA strategies produce improvements compared to the base case. In Strategy 1.7% 9.
is managing director of Tomlinson Financial Planning. Substituting SPIAs for bonds will support higher stock allocations without undue risk of failure. He also does research and writing on financial planning and investment topics. His practice focuses on retirement planning.com/subscribers/subscribe. . visit: http://www. Advisor Perspectives.advisorperspectives. Inc. His article also referred to research with Michael Kitces that analyzed SPIAs and glide paths in a different manner than I do here. During the course of retirement. Client characteristics such as age.com For a free subscription to the Advisor Perspectives newsletter. Joe Tomlinson. This SPIA amortization effect is explained in detail in Wade Pfau's August 6 Advisor Perspectives article.advisorperspectives. required withdrawal rate. and they reach somewhat different conclusions. and other sources of income such as Social Security must factor into what works best in individual cases.000). although intuitively appealing.php -6© Copyright 2013. All rights reserved. while the remaining balance of other savings will follow an independent path. Therefore.$250. does not improve retirement outcomes. and now the bequest values end up above the base case. Decreasing equity allocations over the course of retirement. marital status. an initial allocation involving SPIAs will not continue at the same percentage of overall assets over the course of retirement without annual adjustments. SPIAs (and likely other types of fixed annuities) can serve as bond substitutes and also reduce the risk of outliving one’s savings. the present value of remaining SPIA payments will decline similar to a mortgage amortization. LLC in Greenville. Maine. although client tolerance for short-term volatility also has to be considered. This analysis has indicated that stock allocations toward the higher end of the range offered in TDFs provide better retirement outcomes. Anyone with a strong interest in this subject should read their work as well as mine. an actuary and financial planner. www. Implications for advisors Advisors will increasingly encounter clients who approach retirement with substantial investments in TDFs. They will need to evaluate the suitability of the stock allocations and glide paths to meet retirement needs.
This action might not be possible to undo. Are you sure you want to continue?
We've moved you to where you read on your other device.
Get the full title to continue listening from where you left off, or restart the preview.