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Kitces: Avoid the retirement danger zone

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The final decade leading up to retirement, and the first decade of retirement itself, represent a retirement danger zone — where the size of ongoing contributions and the benefits of continuing to work are dwarfed by the returns of the portfolio itself.

There are many strategies for limiting clients’ equity exposure, although some of the most popular — such as target date retirement funds — may deprive clients from substantial market gains during their post-work years. What follows is an overview of a potential solution to this problem: the bond tent.

Saving for retirement is often framed as a long-term effort of systematic saving and years of compounding growth. But in the early years, whether you save is more important than the growth you earn, because the portfolio isn’t large enough for the earnings to have a material impact. It’s only after a decade or more of saving that eventually the annual return of the portfolio begins to exceed the impact of direct contributions to it.

For instance, saving $300 per month allows an account balance to grow to $3,600 by the end of the first year. In the second year, the account may grow slightly, but the increase in the balance will again be driven primarily by the contributions, as a year’s worth of growth may still be less than a single month’s worth of contributions.

After 10 years of the same behavior, though, suddenly just half of the annual increase in the account balance is driven by new contributions, while the remainder is driven by growth on the existing balance. After 20 years, growth will drive 75% of the annual increases in the account balance. After 30 years, it’s almost 90%.

This phenomenon is known as the portfolio size effect: the mathematical recognition that in dollar terms, the impact of a portfolio’s returns is dependent on the portfolio’s size. And while this mathematical truth may seem self-evident, it has significant implications for the accumulation and de-cumulation of retirement portfolios. Because the portfolio size effect means that not only does growth produce a greater dollar amount of gains on a larger portfolio, but a market decline also produces a larger dollar amount of losses.

In fact, this is one of the primary reasons why retirees face sequence of return risk in their first decade of retirement. Because the portfolio is the largest in the first decade of retirement, even retirees who are spending down don’t normally spend more than their growth until at least the second decade of retirement. This means that an ill-timed bear market takes its biggest slice when the portfolio’s size is at its peak, potentially leaving the portfolio with too little in dollar terms to sustain the retiree’s current standard of living. After all, a mere 20% decline on a portfolio in a bear market evaporates five years’ worth of spending at a 4% withdrawal rate.

Similarly, prospective retirees in the final decade leading up to their retirement also face a problem with the portfolio size effect. The good news of a growing retirement portfolio is that it’s possible to bridge a significant shortfall in the nest egg just during the last few years before retirement, because the growth is so significant in dollar terms as the account balance rises.

The bad news, however, is that a bear market in the final years before retirement can set the retiree so far back that later years’ ongoing contributions can’t possibly make it up, forcing a substantial delay in retirement. In other words, the portfolio size effect leaves the prospective retiree increasingly exposed to substantial retirement date risk as the portfolio becomes almost entirely reliant on a few years’ worth of growth to bridge the final gap.

Simply put, the portfolio size effect leads to a substantial retirement red zone that covers the final decade leading up to retirement, and the first half of retirement itself, where the portfolio’s value is so large that a potential market decline can have a catastrophic impact — presuming a fixed standard of living that the portfolio is intended to support.

The double-edged nature of the portfolio size effect — that it makes good returns even better in dollar terms, but market declines more adversely impactful — raises challenging questions about the optimal asset allocation glidepath through the accumulation and de-cumulation phase.

On one hand, the fact that positive returns do even more to get the prospective retiree to their nest-egg goal suggests that portfolios should just continue to be aggressive, or even get more aggressive, as the retirement date approaches. After all, Robert J. Shiller has noted it’s rather ironic that savers would be more aggressive in the early years, when the growth has little positive financial impact, and conservative just as they approach retirement and the portfolio’s size would make it easiest to catch up on any retirement shortfall.

Similarly, Anup K. Basu and Michael E. Drew find that the amount of money that prospective retirees have on the retirement date is driven almost entirely by their asset allocations in the later years, and not the early years, given the portfolio size effect. And Robert D. Arnott has called the presumed benefit of the conventional target date fund glidepath — which presumes a decreasing equity exposure as retirement approaches — an illusion.

While growth can help more when the portfolio’s size is larger, and markets do go up on average and go up more often than they go down, it’s important not to understate the consequences of how an ill-timed bear market can set back a retiree’s goals.

This is especially important when recognizing that compounding wealth beyond a certain point has diminishing marginal utility — i.e., extra growth from the portfolio size effect is nice, but the second million isn’t nearly as rewarding as the first. And the research going all the way back to Daniel Kahneman and Amos Tversky’s Prospect Theory shows that we are risk-averse in that we experience the pain of losses more than the upside of gains.

Even though the portfolio size effect will arguably be positive more often than negative, Wade Pfau has shown that once a glidepath analysis incorporates these utility impacts, the conventional wisdom of decreasing equities in the years leading up to retirement makes sense after all.

And notably, as shown earlier, the potential adverse impact of the portfolio size effect applies in retirement as well, which in turn means getting more conservative with the portfolio as its value peaks is not just about reducing equity exposure in the years leading up to retirement, but also in the first decade of retirement, too.

Accordingly, our prior research for retirees has found that a rising equity glidepath — which is more conservative in early retirement and gets more aggressive later — can also improve retiree outcomes by limiting their exposure to potentially adverse market volatility when the portfolio size effect is greatest.

All of which means the optimal equity-exposure glidepath model for managing the risks associated with the portfolio size effect would adopt a V shape: getting more conservative in the decade leading up to retirement, remaining conservative in early retirement and then drifting at least somewhat higher again in the later years.

Viewed another way, if the portfolio size effect reflects when the portfolio — and the goals it is intended to support — is at the greatest risk for a catastrophe, the way to manage the danger is simply to take the least risk when the portfolio is at its largest.

From the traditional equity-centric perspective of portfolio management, using a V-shaped asset allocation glidepath may seem counterintuitive, particularly when it comes to having a more conservative portfolio in the early retirement stage and then allowing it to become more aggressive again later. However, when viewed from the perspective of the portfolio’s bond allocation, the strategy appears far more logical.

After all, the fundamental purpose of bonds in a traditional portfolio is to reduce the portfolio’s volatility, which means a larger portfolio would be at less risk for a substantial loss. Bonds can achieve this outcome by being an outright volatility dampener, given they are less volatile than stocks, and swapping stocks for bonds reduces the portfolio’s overall volatility. Bonds also work as a diversifier, and since stocks and bonds are not correlated, total portfolio volatility may decrease even further. Notably in this context, the point of the bonds is not to drive returns, but to manage retirement risks — which is why they’re appropriate to own, even in a low-yield environment.

Accordingly, from the bond perspective, the V-shaped glidepath turns upside down, and the prospective retiree actually accumulates extra bonds in the years leading up to retirement, and then spends down that volatility-dampening bond reserve in the first half of retirement. By the end, the retiree will finish with a bond allocation that is higher than it was in the early accumulation years, but lower than it was when the portfolio was at its peak value — and, by extension, peak portfolio size effect risk.

In essence, the strategy to protect against the retirement danger zone and the risks that come with the portfolio size effect is to build a bond tent: an upside-down, V-shaped extra allocation to bonds that gets built up in the final years before retirement, and gets spend down in retirement’s early years. This allows the portfolio to take shelter in the tent during the riskiest years of being exposed to the portfolio size effect — not because bonds have an appealing return, but simply because they reduce the volatility risk that becomes so severe at the portfolio’s maximum size.

Notably, there’s still far more research to be done to optimize the exact shape and the slope of the V-shaped equity glidepath and the bond tent. It’s not entirely clear how quickly during the pre-retirement red zone that the bond allocation should build, nor how quickly it should be liquidated in the early retirement years. It may be that equity exposure should be shaped more like the letter U than V, such that the bond tent would have a wider roof — an extended period of time where greater bond allocations are held as a reserve.

And the exact height of the bond tent — that is, how high the bond allocation should reach — may be further optimized as well, especially given today’s low-yield environment, where bonds are less appealing to hold relative to historical standards, but still better than holding equities with even greater volatility and sequence risk. And of course, there are other fixed-income alternatives aside from traditional bonds that might be considered as volatility dampeners and diversifiers as well.

Nonetheless, a wide base of research suggests that some pre-retirement decreasing glidepath in equities — and building of the bond position — is appropriate, and even our original rising equity glidepath over the entire 30-year retirement time horizon helped defend against a subset of the most adverse scenarios, and an accelerated glidepath over just the first half of retirement helped slightly more.

This all means that some kind of V-shaped equity glidepath —building a bond tent in which the retiree can take shelter during the retirement red zone, when the risk of the portfolio size effect is greatest — appears to be more effective than the traditional lifecycle or target date fund asset allocation glidepath, which just gets lower and lower throughout retirement and may actually amplify the risk of a bad sequence of market returns.

Would you consider recommending a V-shaped equity glidepath in the years immediately before and after retirement? Does the idea of a bond tent — building a reserve of bonds during the years of greatest risk — make sense as a retirement strategy? Please share your thoughts in the comment section.

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