Comparing Asset Allocation Approaches in Retirement Income Planning

The American College of Financial Services
September 1, 2017

An important issue in retirement income planning is choosing and adjusting the retirement portfolio’s asset allocation over time. With retirement income planning, the goal is not just to accumulate wealth, but to have sufficient assets to meet income needs throughout retirement. In these three video interviews, Professor David Littell and Dr. Wade Pfau from The American College of Financial Services discuss three approaches to adjusting asset allocation: age based, valuation based, and funded basis approaches. These approaches ultimately target portfolio volatility, which is a problematic issue in the distribution phase of retirement. Financial advisors who are working in retirement income planning should be familiar with the following approaches.

Age Based Asset Allocation

Age Based Asset Allocation Approaches

In the first video, “Age Based Asset Allocation Approaches,” Professor Littell and Dr. Pfau discuss the most common example of age based asset allocation approaches – target date funds (also known as life cycle asset allocation funds). Target date funds are designed to have a higher allocation to equities under the assumption that retirement is many years away, and typically hold a decreasing allocation to equities as retirement approaches. The theory behind this equity glide path is based on the changing combination of human capital and financial assets. When people are younger, most of their wealth is stored as part of their human capital – future salary and earnings – rather than in their financial portfolio. It is important to keep in mind that portfolio losses early in the career can be made up with additional savings. However, when financial assets have grown closer to retirement, portfolio losses can dominate any additional contributions.

When looking at how target date funds address asset allocation during the post-retirement phase, there are two approaches: “to retirement” and “through retirement.” Both types of target funds gradually reduce the allocation to equities in order to reach a conservative allocation by the point of retirement. Funds that use the “to retirement” approach maintain a plateaued asset allocation all the way to the end of retirement, whereas the “through retirement” approach continues to reduce the allocation to equities through retirement. Dr. Pfau points out that continuing to reduce the allocation to equities is based not on a human capital argument, but on the assumption that there is an increasing aversion to risk as people age.

Interestingly enough, these approaches do not line up with much of retirement income research. In Bengen’s safe withdrawal rate research, he argued that maintaining 50 percent to 75 percent in equities throughout retirement is the best approach. Evidently there is a significant disconnect between target date funds and Bengen’s research.

Pfau also discusses the approach that he and Michael Kitces have researched together – an increasing allocation to equities approach. Like the target date funds, the allocation is dropped to about 30 percent in equities by the point of retirement. However, after retirement there is an increasing allocation to equities through the end of retirement. This U-shape approach addresses one main observation: most retirees wish to have the least exposure to market risk when they are the most susceptible to volatility – at or near the point of retirement.

The Pfau and Kitces approach is a risk management technique that provides an alternative to Bengen’s steady, flat (50 percent to 70 percent) allocation to equities. When tested against the Bengen approach, Pfau found that the U-shaped allocation supported spending rates that are equal to or greater than the spending rates with a higher flat allocation to equities, while reducing risk by lowering the average stock allocation over the retiree’s lifetime. Even so, Pfau admits that the rising glide path remains a controversial strategy; though some have been able to accept it and even view it as a traditional and safe strategy, it is challenging for those who are used to lowering the stock allocation as retirement progresses.

For advisors interested in executing a rising equity glide path in retirement, Dr. Pfau points out that a portfolio consisting simply of income annuities and equities can accomplish this goal. As the income annuities are used up and have less value, there will inherently be a natural rise in the equity allocation.

Valuation Based Asset Allocation

Valuation Based Asset Allocation Approaches

In the second video interview, “Valuation Based Asset Allocation Approaches,” Dr. Pfau describes valuation based asset allocation models. He says they combat sequence of returns risk by reducing stock allocation when the stock market is deemed to be overvalued – typically when the largest stock market drops occur. The valuation based asset allocation strategy can reduce volatility at a point in which an individual is at the highest risk of a negative return. Pfau continues to explain that retirees should lock in their gains by reducing their allocation to equities after high returns because what goes up in the market tends to come down. Although predicting market returns may be difficult, Pfau stresses that retirement income planning is a long-term planning problem that requires constant adjustments in order to place oneself in the best position.

The video goes on to discuss specific methods for determining stock valuation and approaches to changing allocation based on valuations. A common valuation method is to use Robert Shiller’s PE10. This is the average price to earnings ratio over a 10-year period. Shiller looked at the relationship between the PE10 and future equity returns. He found a negative relationship: when the market is overvalued, future stock returns tend to be lower. Pfau explained that PE10 explains about 30 percent of the subsequent volatility in market returns over this 10-year horizon. However, he goes on to say that the same PE10 measurement can explain 60 percent of the volatility over a 19-year period. This, Pfau elaborates, moves us closer and closer to a retirement problem when planning over a 30-year retirement horizon.

There have been a number of studies that answer whether changing the asset allocation based on the PE10 is actually successful. Specifically, Pfau cites Graham and Dodd’s study, which considered a baseline asset allocation of 50 percent equities and 50 percent bonds. It then prescribed that if the PE ratio were to rise to over 4/3 of its historical average, to cut stock allocations to 25 percent stocks, and if PE10 were to fall to less than 2/3, to then increase stock allocations to 75 percent. Pfau also reflects on his own 2012 study that tested how the Graham and Dodd approach affects a retirement scenario. He found that the approach did in fact noticeably increase the safe spending rate as compared to just using a 50 percent asset allocation through retirement.

Pfau ends by stating that there is some underlying uncertainty as to whether or not this approach would work in the future. First, as the strategy has become more popular that in itself could lessen its effectiveness. Moreover, the market has since been much more highly valued – with a PE ratio of around 27 – than its historical average PE ratio of 16. There are also other factors to consider such as changing accounting standards and returns on capital falling as people become wealthier. In summary, although Pfau does advocate for adjusting asset allocation based on market valuations, using the PE10 as the appropriate allocation method may need to be reconsidered.

Funded Ratio Asset Allocation

Funded Ratio Asset Allocation Approach

Finally, in “Funded Ratio Asset Allocation Approach,” Professor Littell and Dr. Pfau go over the third method of asset allocation – the funded ratio asset allocation approach. Pfau explains that funded ratio management is based on asset liability matching – how pension funds do the asset allocation. Liabilities that need to be met by pension funds are matched with assets in order to be covered safely and securely (i.e. holding a bond until it matures and then providing income for that year). Funded ratio management applies this kind of framework to retirement income problems at a personal level.

Moreover, Pfau presents Jason Branning and M. Ray Grubbs’ Modern Retirement Theory – a funding hierarchy developed to explain funded ratio management using different liabilities that must be covered in one’s retirement. The hierarchy prioritizes these needs from the bottom up: essential spending needs, then a contingency fund for unexpected expenses and retirement risks, then discretionary expenses to meet overall lifestyle goals, and finally the legacy objective. The Modern Retirement Theory summarizes the liabilities of the traditional retiree client that must be covered under this method.

Keeping the Modern Retirement Theory in mind, assets must be matched to these liabilities by risk characteristics. For example, a retiree should not plan to have stocks covering essential spending needs or contingencies. However, stocks may be a pragmatic option to contribute to the legacy fund. The safest, most secure, and sustainable assets should be used to cover the highest priority spending needs and essentials that are on the bottom of the Modern Retirement Theory pyramid.

The funded ratio attempts to simplify this matching process and comparison all into one number: the present value of all liabilities relative to the present value of all available portfolio assets. A funded ratio of 1.0 would imply a case of being perfectly funded; the retiree has the perfect value in assets to fund his or her expected liabilities. Similarly, a funded ratio less than 1.0 implies being underfunded – the retiree does not have enough in assets to sustain his or her expected liabilities A funded ratio greater than 1.0 implies being overfunded – the retiree has over enough in assets to sustain his or her expected liabilities.

Pfau addresses the sequence of returns risk when reviewing the potential risks of the funded ratio asset allocation. He explains that it is especially important to consider the sequence of returns risk when a retiree is just barely funded (a funded ratio just over 1.0). This is because any negative market return at this point can turn a retirement from being fully funded to underfunded. That being said, it may be a smart decision to have the lowest stock allocation when a retiree has a funded ratio at or just above 1.0.

Pfau points out that the further away the funded ratio is above 1.0, the safer it becomes for discretionary wealth to be invested more aggressively, as essential needs have already been covered. He describes this as having “excess wealth,” which can almost be viewed as “portfolio insurance.” Pfau also acknowledges that there may be times in which a client is underfunded. Although the mathematically optimizing solution is to become more aggressive with investments, clients may not feel comfortable with this. Doing so could solve the problem or possibly make it worse. For the client that is underfunded, Pfau provides three additional practical solutions:

  1. Increase assets (work longer, delay Social Security)
  2. Decrease liabilities (reduce spending)
  3. Monetize mortality (use an income annuity)

These videos remind us of the complexity of retirement income planning, and the importance of choosing methods for managing portfolio risk in retirement. The material discussed in this blog post provides a glimpse into the type of content covered in the RICP® curriculum, a critical designation to earn for those financial advisors who wish to provide effective, comprehensive advice to retiring and retired clients.