Thursday, September 18, 2014

A Challenge and a Response for Rising Equity Glidepaths in Retirement

Jared Kizer of the BAM ALLIANCE recently wrote an article called, “An Analytical Evaluation of Rising Glidepath Claims” which concludes that there is no value in using a rising equity glidepath during retirement, contrary to the conclusions that we (Wade Pfau and Michael Kitces) reached in research published in the January 2014 Journal of Financial Planning. We welcome feedback and criticism of our research and are willing to make changes when justified (in fact, just this week we released our own follow-up research showing that rising equity glidepaths are only best in a narrow set of specific circumstances, albeit ones that are present today). But in this case, while we both have a lot of respect for the research and books generated by Jared and his colleagues at the BAM ALLIANCE (such that we took his article quite seriously), we don’t think his criticisms hold under scrutiny.

As the BAM ALLIANCE P.R. department has shared Jared’s article with a large number of media outlets, we feel it’s important to explain why we disagree with the conclusions in Jared’s article. The issue, though, is that we think there are some important problems with Jared’s statistical methodology, and so the discussion in his article and here will be hard to follow for readers who haven’t taken or don’t recall much of what they learned in their statistics or econometrics classes. Nonetheless, after the national media blast, Michael and I need to get our side of the story out there as well.

Probability of Failure

The article begins by making a useful point that if one strategy has a success rate of 80 percent while another is 81 percent, then you can’t really say with confidence that the second strategy works better. There will always be a degree of randomness in the results, and even if the difference in success rates is “statistically significant” in the way that statisticians like to use the term, there is still not much real world practical difference between the numbers.

This is why Michael and I generally frame the results as it being possible with a rising equity glidepath to get just as good of outcome, or possibly even better, using a lower average equity allocation. For example, starting retirement at 30% stocks and slowly increasing to 60% stocks can do just as well, and maybe even better, than just sticking with the 60% stock allocation over the whole retirement period (presuming the client had the tolerance to own 60% stocks in the first place and would have done so absent further advice). We did not attempt to test whether this result is “statistically significant” as an improvement, because the mere fact that a portfolio with significantly less equities getting the same result is still meaningful, though we did find indications that there may be some modest improvement in outcomes as well. In the quote Jared used from our article, we said that rising glidepaths have “the potential” to improve outcomes. The safe withdrawal research says that retirees should hold 50-75% stocks over their whole retirement as a way to minimize the risk of depleting their wealth, and we are saying that this isn’t necessarily the case. Those not comfortable with such high stock allocations can have some comfort with our conclusions.

When Jared gets to the first table in his article, he’s approaching this matter from an entirely different perspective. He’s asking a different research question than what we considered. Table 1 is showing whether rising equity glidepaths as a whole (representing the 55 different rising glidepaths we considered) can support a higher average success rate for the 4% rule than declining equity glidepaths as a whole (representing 55 more cases). The answer he finds is that there is not much statistical evidence to suggest that rising glidepaths are superior as a whole. Also, which has the higher average success rate depends on the choice of capital market expectations – which we actually wanted to illustrate, and is why we tested the analysis with a wide range of capital market assumptions.

Are rising equity glidepaths superior as a whole? Perhaps not, but that wasn’t what we were saying in the first place. As Michael explains it by analogy – our study set out to determine if reputable fund manager DFA funds provides better performance than other mutual fund families or traditionally-weighted index funds, so we compared the long-term track record of DFA to the other fund families and index funds, and concluded that DFA funds do in fact provide a benefit. Jared’s analysis is the equivalent of then coming back in, and measuring whether the AVERAGE of DFA funds AND ALL OTHER MUTUAL FUNDS outperform the indexes, with the conclusion that they do not because all the fund managers in the aggregate are underperforming by the average of their fees. He then concludes that DFA cannot possibly provide value, because the average fund manager underperforms the index. Yet the conclusion is not actually logically coherent; even if the average of all mutual funds underperform an index, it’s not proof that a particular fund can’t still be superior. We were looking for whether the best fund (or in this case, the best glidepath strategy) can be superior, not whether the average fund (or average glidepath strategy) is superior, while Jared just measured the average and then used it to make a logically inappropriate conclusion about a particular fund/glidepath strategy.

Furthermore, by including the average of all the glidepaths we tested, Jared’s analysis ends up including scenarios that we presented for the sake of thoroughness, not because we were ever actually advocating them (even after the study was published). We're more interested in whether rising glidepaths will work for situations that real retirees might consider, i.e. we don’t care too much if a 0% to 10% glidepath isn’t as good as a 10% to 0% glidepath, since neither should be very realistic choices in the first place. 

In addition, there is an important problem with what Jared does here, though he doesn’t start to discuss the problem until later in the article. The issue is that our collection of rising equity glidepaths will have a lower average stock allocation than our collection of declining equity glidepaths. Looking just at initial stock allocations, the rising glidepaths have an average value of 30% stocks, and the declining glidepaths have an average value of 70% stocks. With the 2nd set of capital market expectations, the success rate for the 4% rule with a fixed 30% stock allocation is 51%, and the success rate is 66% for a fixed 70% stock allocation.

So our rising glidepaths have a severe hurdle to overcome, especially in scenarios where the capital market assumptions are assumed to be especially bad for bonds relative to stocks. Just having the rising equity glidepaths remain competitive on these average success rate measures is a good sign, and while some investors are very pessimistic about markets and might use those low capital market assumptions, others are more optimistic about returns and the rising glidepaths hold up even better in those environments.

But the bottom line is that something close to the same basic outcomes is being achieved with a collection of glidepaths using a lower stock allocation. Risk averse retirees can feel much better now. Actually, this really was our point all along. And saying that the rising equity glidepath represents a more conservative strategy is not an indictment of rising equity glidepaths; it was actually our point!

Magnitude of Failure

Next Jared looks at the magnitudes of failure.  His second table actually shows support for rising glidepaths. He shows that the magnitudes of failure (based on our own data and results) are less severe with rising glidepaths in all three cases for capital market expectations, and that all of these results are highly statistically significant. Apparently unsatisfied with this conclusion, though, he now brings up the issue that rising glidepaths have lower average stock allocations, and suggests that perhaps the favorable results of the rising glidepaths are simply being driven by the fact that they have lower average stock allocations. Fine (since we actually made that point as well!). The problem is that his next choice of regression is not an appropriate way to try to conclude that it is only the lower stock allocations that matter, and not the direction of the glidepath as well.

Even though he left Table 1 as is (which shows the probabilities of success across the strategies, as analyzed earlier), despite this issue of average stock allocations being different, he decides that we cannot use Table 2 (which shows the same results as Table 1 but looks at magnitudes of failure instead) because now he is concerned the rising glidepaths have less stocks. To account for this, he creates a regression model to see how the magnitude of failure relates to two variables: the starting equity allocation and a dummy variable equal to “1” if it’s a rising glidepath and “0” for declining glidepaths. Running this regression suggests that it’s the initial stock allocation that matters, and that the fact that one uses a rising equity glidepath provides a net negative contribution to the results for one of the three sets of capital market expectations (results are not significant in the other two cases). In other words, this is where he really concludes that rising glidepaths are bad, and any benefit we showed actually relates (in his view) only to the fact that the retiree starts at a lower stock allocation, and not to what subsequent glidepath is.

This regression is where we have the biggest disagreement with Jared’s methodology. As indicated, his two variables are initial stock allocation and whether it is a rising glidepath path or a declining glidepath. This choice of variables effectively discards the important information about the magnitude of changes in the glidepath. In other words, there is nothing in his regression to distinguish the important difference between starting at 20% stocks and ending at 30% stocks or ending at 100% stocks. There would be 10 rising glidepaths which start at 0% stocks, and there would be 10 declining glidepaths which start at 100% stocks, and they all appear exactly the same in his regression analysis. But they are not the same! He ignores the magnitude of changes in the glidepath, which can be very material (in terms of both risk and outcome).

The reason Jared set up the regression this way is because believes that the initial stock allocation is the best available estimate for what the average stock allocation will be for the whole retirement. While a portfolio that glides from 30% in stock to 60% over 30 years would have an average allocation of 45% over time, Jared emphasizes that if the portfolio is being spent down, the dollar-weighted allocation will be closer to 30% than 60% (or that it’s at least a close enough approximation even though the dollar-weighted average will vary in each particular Monte Carlo simulation). But we think it is a severe mistake to completely ignore information we have about the magnitude of change in the glidepath. A 0% stock allocation which ends at 10% stocks will not create the same experience for a retiree as a 0% stock allocation that ends at 100% stocks. To say that both are equally well represented by the fact that their initial allocation was 0% is insufficient when one ends at 10% and the other ends at 100%. A proper regression model should do something to account for this.

So how do we correct the problem? Well, we're not all that enamored with this regression approach in the first place. The number of datapoints is somewhat artificial based on the fact that we looked at the glidepaths in 10 percentage point increments. There would have been 15 rising glidepaths if we used 20 percentage point increments, and there would have been 5,050 rising glidepaths if we used 1 percentage point increments, creating strange artificial thresholds to finding significance in the first place. That being said, I think it is still fair to overweight the initial equity allocation (as with a portfolio that spends down, the dollar-weighted allocation will be closer to the starting percentage than the ending), but let’s also do something to avoid wasting the information about how quickly the glidepath changes. For example, we could let the regression variable be equal to:

0.7 * starting equity allocation  +  0.3 * ending equity glidepath

This is still reflecting the importance of the initial stock allocation, but it is also letting the changes in glidepath play a role as well. I simply can’t understand why Jared believes that only considering the initial stock allocation is a better way to investigate this. We can re-run the regression with this new variable, and then we can look at the coefficient on the dummy variable and decide about the rising glidepath.  Here is our version of his third table in which we use this new variable better reflecting the average stock allocation over the retirement:

Dummy Variable Coefficient
Capital Market Expectations I
Capital Market Expectations II
Capital Market Expectations III

Again, we're not so excited about this regression approach in the first place, but in the context of how Jared presented his results, this table shows overwhelming evidence in favor of rising equity glidepaths. The coefficients on the rising glidepath dummy are all positive, suggesting that once we control for our approximation of the average stock allocation over retirement, rising glidepaths give substantially better results in terms reducing the magnitude of failure, relative to declining glidepaths. In addition, those t-statistics are quite large, suggesting that the results are all highly statistically significant. This table is very good news for rising glidepaths.

The important difference, and why this regression is better than the one Jared used, is that this regression also allows the degree of change in the glidepath to play a role as well. As we explained before, Jared’s approach threw away too much information because it only used the starting equity allocation. 

Beyond that, it’s also worth noting once again that we can view the fact that the rising equity glidepath is a path to starting with a more conservative portfolio is also a benefit of implementing the glidepath strategy itself. Continuing the earlier example of analyzing the benefits of using DFA funds, a Kizer-style regression analysis on DFA fund holdings might easily find that DFA funds are disproportionately tilted towards small-cap and value stocks (which isn’t surprising, as DFA’s philosophy is to implement the small-cap and value tilts of the Fama/French three-factor model). By Kizer’s methodology, this implies that using DFA funds has no benefit, because the actual benefits are simply a result of the small-cap and value tilts, not recognizing that the whole point of using DFA funds was to implement those exact tilts in the first place. In addition, while DFA’s beneficial results might be dominated by their small-cap and value tilts, they arguably provide some value in their particular implementation of the strategy as well, yet it clearly seems too narrow to suggest that DFA’s only benefit is the way they invest the tilts and not the fact that they decided to apply the tilts in the first place. Similarly, while we’d actually concur that a significant (though not exclusive) factor of the rising equity glidepath is that its initial equity weighting is lower, the path of the glidepath itself over time does matter too, and the overall value of the strategy is not just about the path of the glidepath but also the fact that it creates a framework to make it acceptable to own that lower initial equity allocation in the first place!

Wednesday, September 17, 2014

Retirement Risk, Rising Equity Glidepaths, and Valuation-Based Asset Allocation

Michael Kitces and I have completed a new research article called, "Retirement Risk, Rising Equity Glidepaths, and Valuation-Based Asset Allocation." It's now available as a working paper at SSRN.  

This morning, as well, Michael has written a detailed overview of the research at his Nerd's Eye View blog. A funny point about that. With our last article, I think a lot of people became familiar with it from Michael's blog post.  Twice now, I've been speaking to groups of financial planners, and someone has asked me if I'm aware of the recent research about rising equity glidepaths in retirement. Everyone gets a good laugh as I awkwardly answer that I am aware of the research, since I'm actually one of its co-authors.

In order to avoid overlapping too much with Michael's excellent overview, let me take a different angle in an attempt to summarize this new research article. It all begins with sequence risk, which is the idea that even if the average market return is decent, retirees are especially vulnerable to the impact of bad market returns in the early part of their retirement. Sequence risk is uniquely caused by the attempt to (1) spend a constant amount each year from (2) a volatile investment portfolio. Sequence risk can be dampened by either letting spending fluctuate or by reducing portfolio volatility. For this research, we are focused on the 'reducing portfolio volatility' side of the equation.

Outside of just using a low equity allocation throughout retirement (which leads to its own sets of risks in terms of potentially being locked out of any possibility to meet one's spending goals), we can identify three major ways to reduce portfolio volatility when it counts the most:

(1) rising equity glidepath:  reduces portfolio volatility in the pivotal years near the retirement date when a retiree is most vulnerable to losing the most dollars of wealth with a given market drop. People are most vulnerable and have the most at stake when their wealth is the largest.  

(2) valuation-based asset allocation: reduces the stock allocation when the portfolio is the most vulnerable to experiencing a big decline in value, which historically has happened when Robert Shiller's cyclically-adjusted price earnings ratio has risen to levels well above its average (i.e. 1929, the mid-1960s, and 2000). 

(3) funded ratio: Reduces portfolio volatility when the retiree has enough assets to just get by with meeting their retirement spending goals using a low-volatility portfolio.  Once the retiree has excess 'discretionary' wealth beyond what is needed to safely lock in their goals, that's when they can invest more aggressively with a volatile portfolio. In other words, reduce volatility when you are most vulnerable to a transition from being able to meet your goals to not being able to meet your goals.

This new research focuses more on the interplay between using different glidepaths and using valuation-based asset allocation. 

We clarify that the rising equity glidepath does not necessarily have to be used as a universal situation.  However, today's investing environment does reflect the circumstances when the rising glidepath is most useful. That is, the stock market is overvalued and is more vulnerable to a significant drop. This is when the rising glidepath works best: it lowers the stock allocation to help guide through the environment when the retiree is most vulnerable to a market drop, and presuming such a drop happens at some point, it will then be shifting to a higher stock allocation later in retirement when markets are more fairly valued. In other words, it approximates a valuation-based asset allocation strategy.

When markets are not overvalued, which does not reflect the situation today, then retirees might look more carefully at just holding a higher stock allocation, or at using a valuation-based asset allocation strategy. If markets are undervalued, the traditional type of declining equity glidepath in retirement can actually look more attractive, as it provides a closer proxy to what would be done with a valuation-based strategy.

In conclusion, in today's overvalued market environment, retirees can reduce their vulnerable to the effects of a big drop in the stock market by using a lower equity allocation. This can be accomplished either by using a pre-set rising equity glidepath (as an inverse of what today's target date funds do for the pre-retirement period), a valuation-based strategy, or even a combined rising equity glidepath with a valuations overlay. This is the subject of our new article at SSRN

Tuesday, September 16, 2014

Updates on Recent Articles

The blog been quiet recently, but it's not been because of a lack of things to talk about. It's just, once you're out of a routine, it's tough to get back into it. And I've been keeping busy with a lot of new research projects. I might actually have a full schedule of blog posts for the rest of the week to discuss some of this recent research that's now actually getting to the stage of going public. 

To get things started, let me provide an update on some recent columns I've written at different places around the Internet, as well as a note about a webinar I will participate in on Thursday.

Now is a Tough Time to Retire

In the column, "Now is a Tough Time to Retire," at Financial Advisor magazine, I write about a question I am commonly asked, which is whether it is a bad time to purchase an income annuity or buy individual bonds because interest rates are low.  My answer is: not necessarily, relatively speaking. More generally, it's a tough time to retire as everything is expensive. Income annuities are not necessarily worse position than other approaches in our low interest rate and high market valuation world. 

The Power and Limitations of Monte Carlo Simulations

David Blanchett and I have written a two-part series about Monte Carlo simulations for financial planning (and a third part is on the way) at Advisor Perspectives. The first article, "The Power and Limitations of Monte Carlo Simulations" provides a discussion about how Monte Carlo simulations are used in financial planning software. We consider some common critiques about Monte Carlo, and whether these critiques are justified. We also highlight important advantages obtained from a Monte Carlo approach relative to other straightline types of methods. 

Can Retirees Still Use a 4% Withdrawal Rate? Practical Applications of Monte Carlo Analysis

The second part in this series from David and I is called, "Can Retirees Still Use a 4% Withdrawal Rate? Practical Applications of Monte Carlo Analysis." It provides a discussion of different issues and applications related to using Monte Carlo for retirement planning analysis. We conclude that Monte Carlo provides a more flexible tool for retirement income planning than looking at what would have worked in rolling periods from the historical data.

Is the 4 Percent Rule Too Low or Too High?

The topic of the column, "Is the 4 Percent Rule Too Low or Too High?" from the Journal of Financial Planning should be somewhat familiar to readers here, as I've discussed it before. But this column represents my attempt to summarize and distill some key issues into a short column. I've re-written lots of portions from past discussions at the blog.

Mr. Money Mustache

I would be remiss not to mention that one of my favorite bloggers, Mr. Money Mustache, actually included a research question for me to explore in a recent blog post. It's actually a really good question, and I've got it on my to-do list.  The issue is that because of the equity risk premium, generally if one is given a choice in the matter, it will be better to invest the full lump-sum amount all at once, rather than dollar cost averaging the wealth into the markets over time. This maximizes the amount of time that the wealth is exposed to the market. Mr. Money Mustache ponders whether this will continue to hold even when market valuations are at historically high levels, such as today.  I'll plan to take a look at this.

Saving for Retirement: Am I On Track?

Regarding the webinar, Paula Friedman and I will do a joint presentation called, "Saving for Retirement: Am I On Track?" It's actually a very introductory presentation for people just getting started with investing and saving. Paula is director of encore401(k) at McLean Asset Management, and she will discuss some of the basics around saving and investing which she also shares with plan participants in 401(k) plans. I'll join in to discuss "safe savings rates," as a way to approach the retirement planning problem from the perspective of someone who does not wish to spend a lot of time thinking about finance and investments. Given some basic information about your situation, the idea of safe savings rates is to let you know how much you should be saving to have a good shot at achieving your retirement spending goals.

To register for this event, please go to:

Webinar ID: 128-747-283

Date/Time: September 18, 2014 at 1:00 -2:00 PM EDT.

Wednesday, August 27, 2014

Alex Murguia - Quality Control of Financial Planning webinar

I'm passing on a message for advisors from Alex Murguia of McLean Asset Management and inStream Solutions:


Calling all advisors!

I need your help. On September 10th, I will presenting a TED style talk at Bob Veres' Insider’s Forum conference on "Quality Control of financial planning." The topic addresses what I feel is the next big hurdle and a significant value proposition that advisors are facing in our evolving profession. 

In much the same way that advisors have operationalized their investment management services for clients through the use of model portfolios and technology (e.g., i-Rebal & Orion) over the last 10 years, we have only begun to tackle the institutional delivery of financial planning advice. The Implications of this range from how you provide a consistent level of planning advice across your client segments and advisors. 

While I have a good sense of the agenda, I realize that I belong to only one firm. I would appreciate your help in sharing your thoughts with me as I preview my "working" presentation. I have set up an interactive webinar on Wednesday September 3 at 3:00 PM Eastern in preparation for the TED style Talk at Insiders Forum. I would very much value your input. 

Thanks in advance for your help,

Alex Murguia

Wednesday, July 23, 2014

July 29: Educational Webinar on Bond Prices and Interest Rates

A side project which I have worked on in recent months is a bond calculator for the Annexus Research Institute. This calculator allows users to explore the relationship between interest rates and bond prices. On the left-hand side of the calculator, one can calculate the market price for an existing bond based on its characteristics and current interest rates. On the right-hand side of the calculator, one can explore the impact of future interest rate changes on the bond price. 

Bond prices are inversely related to interest rates. If interest rates increase, the prices for existing bonds will decrease so that the yield to maturity earned by anyone purchasing an existing bond would match the yields available on new bonds at the higher market interest rate. The calculator allows users to explore this relationship with realistic bond examples of their choosing.

Rex Voegtlin of the Annexus Research Institute has written a white paper to accompany the calculator, and he has also developed an educational webinar about the relationship between interest rates and bond prices. Anyone is welcome to sign up for this webinar,"The Bond Dynamic of 2014: What Every Successful Advisor Must Know." The webinar is on Tuesday, July 29 from 3 PM to 4 PM Eastern time.  I am not the presenter for the webinar, but I will be in attendance and will be available to answer questions at the end of the webinar.

Though designed for financial advisors, anyone is welcome to attend. When you sign-up there are a series of questions to answer. For those who are not advisors, you can provide the answers seen below as part of signing up:

* First Name (obvious)

* Last Name (obvious)

* Email Address (obvious)

* Company Name (obvious)

* Who is your Internal Marketer/Contact?  Brian

* Who is your Annexus IMO? Annexus

* Please Type In Your Agent Number? Pending

* Are You a Registered Rep? Yes or No


Wednesday, July 16, 2014

From Dirk Cotton's The Retirement Cafe: Half Right

Dirk Cotton recently made an excellent post which provides further background descriptions about what I was doing in a recent Advisor Perspectives column about using Monte Carlo simulations to get conservative return assumptions. Dirk's post is The Retirement Cafe: Half Right. It's also worthwhile to check his comment section.

Monday, July 7, 2014

Two Views on the 4% Rule

I've got a short new column at MarketWatch's RetireMentors called, "Retirement: Two Different Views on the 4% Rule."

The first view is the standard Bengen, Trinity-study approach of basing safe withdrawal rates on historical worst-case scenarios.

The second view is the one I ascribe to, which is that current market conditions are much better indicators of what will be sustainable than historical worst-case scenarios. Historically, Shiller's PE10 has done a good job explaining sustainable withdrawal rates.

This second view is easy to misunderstand. I'm saying that with it, 4.2% is the best guess about the actual sustainble withdrawal rate for current retirees. It's not a safe withdrawal rate. The safe withdrawal rate would be less.

This short column didn't incorporate bond yields, which are also good  indicators about sustainable withdrawal rates. The fact that bond yields are at historic lows also suggests that we will end up on the low side of that 4.2% guess.