A common assumption for studies about the sustainability of income in retirement is that the asset allocation (i.e. the proportions in shares, cash, property and fixed interest stock in your portfolio) remains fixed throughout your retirement. However, one theory suggests that it may be better to gradually increase the percentage invested in shares and other higher risk/reward assets as you get older. This goes against the perceived wisdom that you should reduce the amount you have in riskier assets as you age (which is, frankly, a bit ageist and outdated).

The advantage of doing that is that it helps to deal with some of the key risks you face when withdrawing a regular amount from an investment portfolio (whether that portfolio is in a pension, an ISA or anything else).

Retirees are especially vulnerable to the impact of bad market returns as they retire and shortly afterwards, even if the return is good, when averaged out over the entire period of retirement. “Sequence risk” (often called “pound:cost ravaging”) is a risk which only affects portfolios where a fixed  amount is withdrawn each year from an investment portfolio, which goes down and up in value.  If you take money out of an asset that has fallen in value, then you haven’t just made a paper loss, you have made a real loss – this is sequence risk, in a nutshell.

There are really only two ways to reduce sequence risk – by letting spending fluctuate or by reducing the amount by which the portfolio, or the investments in it, fluctuate in value. Many people prefer to use the second option – as they prefer not to wait to hear how their investments have performed before deciding how much to spend in the following year; and nobody likes to find out that they have to tighten their belt because markets have done badly.

Outside of just using a low allocation to shares throughout retirement (which comes with the risk of generating an inadequate return), retirement Gods Wade Pfau and Michael Kitces have identified three major ways to attempt to reduce portfolio volatility:

1. To reduce volatility when most exposed to absolute wealth losses (often called a rising equity glide path).
2. To reduce volatility when most exposed to “predictable” market losses (valuation-based asset allocation); this involves trying to guess what markets might do next, which we would not recommend that you ever do.
3. To reduce volatility when financial goals are most at risk (funded ratio).

We can look at options 2 and 3 on other occasions.

Rising equity glide paths for retirement aim to reduce portfolio volatility in the pivotal years near retirement (when a retiree is most vulnerable to losing the most wealth – in terms of Pounds and Pence – when markets fall). People are at greatest risk, and have the most at stake, when their wealth is at its peak, which often coincides with their retirement date.

With a rising equity glide path, the optimum lifetime allocation to shares throughout life becomes U-shaped: the allocation to shares is higher when you are young and saving up, an at its lowest around the retirement date when the risks are greatest, and higher again later in retirement, when the impact is less. The chart below illustrates this general pattern.

Stylized Lifetime Stock Allocation Glide Path with a Rising Equity Glide Path in Retirement

Whilst the idea of a rising equity glide path in retirement contradicts the conventional wisdom says that the proportion in shares should decline with age, it is intended as a risk management technique for people who rely on investments to fund their retirements. It may help support your wealth, and your spending capacity, by protecting you at times when retirement goals may be most at risk.

It may be better that the description of a “rising equity glidepath” is a poor one. It is better described as being an approach in which you start retirement with a lower share allocation than a conventional approach would suggest. Having started with a low allocation, over time you can then increase the amount in shares. Maybe we should call it a “falling cash and bond glidepath” (I’ll never get a job in advertising!).

To understand the concept of a rising equity glidepath, Kitces and Pfau looked at some examples of the investment conditions retirees might face, and they came up with four scenarios.

1. Stockmarkets do well throughout the entire retirement period. In this case, most retirement plans should be successful, regardless of asset allocation, though more aggressive strategies may mean that there is more money left at the end of retirement.
2. Poor stockmarket returns prevail throughout the entire retirement period. If this is the case, there’s not much that can be done. However, a rising equity glidepath would be less bad than a fixed asset allocation.
3. Stockmarkets perform well in early retirement but poorly later in retirement. In this case, sequence risk is not a problem, and you benefit from “sequence reward. A rising equity glide paths will still work, but there will be less money left at the end of retirement.
4. The rising equity glide path excels in scenarios that have historically led to the worst outcomes for retirees. That is, stockmarkets fare poorly early in retirement and then recover later in retirement. These scenarios have created the lowest starting withdrawal rates for past retirees, and this is where a rising equity glide path can make a difference in supporting better retirement outcomes.

What Kitces and Pfau still haven’t managed to work out is how to predict the future. So, you will only know what market conditions have prevailed throughout your retirement, at the end of your retirement (and being blunt, unless you are Lazarus, you aren’t going to know!). However, we do know that a rising equity glidepath can help those who will be most affected by poor returns in early retirement, and if this is a significant risk for you, it may be an approach to consider.

As usual, nothing about retirement income planning is simple and we think that everyone will benefit from professional financial advice. If you would like us to help with your planning, please contact us.

Click on the link if you would like to read the article written by Wade Pfau and Michael Kitces https://www.financialplanningassociation.org/article/journal/JAN14-reducing-retirement-risk-rising-equity-glide-path

Philip Wise | philip@sussexretirement.co.uk

Managing Director and Chartered Financial Planner

This blog is for information purposes and does not constitute financial advice, which should be based on your individual circumstances.

The value of investments and any income from them can fall as well as rise. You may not get back the full amount invested.

Investing in shares should be regarded as a long term investment and should fit in with your overall attitude to risk and financial circumstances.