Thursday, September 26, 2013

How Should FIRE Timeline Affect Asset Allocation?

I was reading an interesting post over at Save & Conquer about the risks inherent to investing, and in the comments Bryce suggested that I consider a glide path for our asset allocation as we get closer to retirement age. We currently use Bernstein's Simpleton's Portfolio, consisting of equal parts of US large company stocks, US small company stocks, foreign stocks, and short term US bonds. Bryce indicated that asset allocation would be fine for now, but as we approach retirement age, we should probably reduce risk.

This got me thinking. We are supposedly seven to eight years away from early retirement, making us the financial equivalent of a typical fifty-eight year old. In retirement years, we're flipping old! Is our asset allocation appropriate for our retirement age? More importantly, with the especially short acquisition time frame & correspondingly longer period of retirement, does the typical glide path asset allocation logic apply? That is, can we afford to get conservative if we are planning to live off our nest egg for sixty years, instead of the typical thirty?

I have no good answers to these questions. At Bryce's suggestion, I read the Bogleheads Wiki on glide paths, which gives a good overview of different popular strategies. The general sense with glide paths is to reduce the percentage of risky equities & increase the percentage of less risky assets (fixed income & money markets) as you approach retirement, & even further as you move through it. The variation in the strategies is in how you move from risky assets to safer ones: straight line, steps down, or in waves that, when graphed, conjure memories of old calculus classes. But the Boglehead wiki, while informative, doesn't specifically talk about early retirees, and whether any specific model (or modification) should be considered.

I poked around on Google and, just to confuse me, the best article I found tells the complete opposite story. Michael Kitces' excellent blog, Nerd's Eye View, argues that instead of decreasing equity exposure in retirement, the prudent strategy is to do the opposite & increase equity exposure in retirement: a "rising glide path." The idea is that the primary risk to a retiree is a bad market in the first fifteen years of retirement. This can mean a once-in-a-generation crash, but the more dire risk is a prolonged period of very meager gains: a long flat market. If a traditional retiree with a downward glide path is unlucky enough to start at the wrong time and starts to liquidate equities then, when the market recovers, he or she doesn't have enough stock exposure to benefit from it. He or she has started retirement with fewer stocks & has been further reducing that percentage over time. The better strategy is counter-intuitive to most retirees: to avoid the risk of a down stock market during the first part of retirement, increase your stock exposure over time during retirement. Kitces goes through an excellent review of the strategy & details it with math & charts that make my brain hurt. Smart people should definitely click the link at the beginning of this paragraph and check it out. Average minded people like me can take his summary at face value:
In this context, the problem with the "traditional" approach of decreasing equity exposure through retirement becomes clear. If the retiree started in an environment like the late 1920s or late 1960s and decreases equity exposure systematically (e.g., by 1% to 2% per year), then by the time the good returns finally show up (about 15 years later) equity exposure will have been decreased so much that there simply won't be enough in equities to benefit when the good returns do show up. In other words, even if spending was conservative enough to survive the time period, selling equities throughout flat or declining markets amounts to liquidating while the market is down and not being able to participate in the recovery and the next big bull market whenever it finally arrives. Conversely, when the equity glidepath is rising and the retiree adds to equities throughout retirement (and/or especially in the first half of retirement), then by the time the market reaches a bottom and the next big bull market finally begins, equity exposure is greater and the retiree can participate even more!
As usual, my attempt to gain knowledge & find a plan has just resulted in confusion. So I'll take the lazy way out and ask you, the smart people who read this blog, to help. Do you think it's better for a retiree to have a declining glide path in retirement or a rising one (or, for a third option, a static asset allocation with annual rebalancing)? While these sources provide contrary strategies, neither of them talks about the wrinkle of early retirement, which involves a much longer retirement period (or, at least we hope it does). Even if one strategy is better for a traditional retiree, maybe the answer is different when you consider a sixty or seventy year draw down period.

And does the short accumulation phase for early retirees (typically five to twenty years) have any impact? That is, should early retirees have a more aggressive or more conservative asset allocation while building their nest egg, given that their plan only accounts for a decade or two of saving?

Questions to the readers:
What sort of glide path are you hoping to employ in retirement? And if you're willing to share, what plans do you have for your asset allocation during your years leading up to an early retirement?

As always, thanks for stopping by and reading.

Photo is from oldandsolo at Flickr Creative Commons.

28 comments:

  1. That's a tough one. I'm not sure there's a "right" answer. For me, I'm looking to stay fairly aggressive in my pretirement years and use my principal as backup, but try not to touch it, and potentially even keep building up. Once I move into traditional retirement, I'll move to a more conservative approach. Rather than looking at odds of a stock market crash at the wrong time, I think about it as when my personal risk NEEDS to be near zero. And that time is when I can no longer find other income -- when I'm old.
    This also touches on why I advocate paying off your house, as well. Once that expense is gone, you are MUCH more able to withstand a crash.

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    1. Hi Nick. I agree that the question probably doesn't have a definitive answer. But I like your thinking: a personal risk profile might inform the right strategy your own FI plan.

      I hadn't thought about how being completely FI might help your ability to not draw down on equities. That's a benefit that doesn't often enter into the analysis.

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  2. I would keep your portfolio invested more aggressively than a typical retiree. Like you said, it needs to last a lot longer. Yes it's higher risk, but if you don't forsee needing to tap into ALL of your investments in the next 10 years, I think you'll be fine.

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    1. Hi Stefanie. Thanks for stopping by. I definitely hope I don't have to tap any of them over the next ten years, let alone all of them. I'd be interested in seeing more analysis, but I agree a more aggressive strategy might be called for.

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  3. Since you are retiring early, and your money needs to last longer, I'd lean towards a more aggressive allocation. Then get a lot more conservative as the more traditional retirement age approaches.

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    1. That strategy fits into a scenario that Kitces outlines: in which an equity heavy portfolio performs well & then has a high enough balance to be conservative later in the retirement.

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  4. I would think you would need to stay a little aggressive. If you try and stay passive, you won't get much growth over the short time frame and have to rely mainly on the money that you put away. My other thought would be to pick a distribution and mainly stick to a periodic rebalance. I think if you shrink or expand your risk allocation you might be more likely to be influenced by the market. This could lead to you timing the market which would be a really bad thing.

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    1. Hi Micro,

      The static distribution is what we're doing now and it's our plan to stick with it. Your last point is a really good one: unless there's some way to automate a glide path, we might be tempted to try to time the market & be influenced negatively by market dips/rises.

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  5. I have to admit that I haven't done enough reading on this particular problem to give you a good answer that's actually backed by anything concrete. It's a great question though, and an important one. My gut feeling would be to probably just stick with the allocation you have now. The Kitces research you mentioned is pretty interesting, as is some of his other work showing the detriment of keeping a large cash reserve in retirement (which has been my thinking, so that threw me for a bit of a loop).

    If I were you, I would hit up the Mr. Money Mustache forums. I haven't spent a ton of time there, but there are a lot of people talking about FIRE and I think you'll find a lot of interesting ideas. Definitely keep us posted on what you find out.

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    1. Hi there, Matt.

      For now I think we'll stick with our current AA until we get a lot more information on the subject. The forums are a good idea: there are a lot of people already in early retirement who might be able to speak from experience & their own research.

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  6. I'm invested in the Vanguard Target 2045 so the exposure to stocks gradually decreases. However I plan on retiring before 2045 but would like to be a little more aggressive. As many above have said...since you want to retire earlier, I do think you have to be a little more aggressive. I agree with Matt that you should check out the forums. Maybe people are in similar situations. Also checkout the Boglehead forums and the FIRE forums.

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    1. I've never been over to either the Boglehead forums or the FIRE forums; thanks for the recommendations!

      It's almost counter-intuitive that we early retirees, with our big savings rates, would have to be more aggressive in our asset allocations...but when you consider the length of our retirement, maybe it's the prudent decision.

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  7. When it comes to investing, in retiree years I am probably at 18. The Romanian stock market is not one many people would invest in, and I am not one of them (although I will just have to start doing it instead of keeping my money in the bank - as hilarious as this might sound, right now this seems like the only logical thing to do). I tried to find ways to invest in the US stock market but all I found was a pretty shady company that wouldn't start on anything lower than $50,000 initial investment, which I am not willing to do (nor do I have all that money). I am still looking and I really hope I'll find a way to start investing soon.

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    1. Hmmm, I've never really considered how other countries might not have access to the same investments. It's odd, too, as we can invest in foreign countries via Vanguard here in the US. Are there equivalents to Vanguard abroad? That might seriously impact any of our decisions to live abroad, too, as we'd need to continue investing.

      As always, C, you've given me lots more to think about. :)

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  8. I think we'll likely be fairly aggressive in our investment allocations for the bulk of our savings, though the part that we expect to save until traditional retirement age might be left in the Target Date (vanguard) funds that it's currently in.

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    1. Hi Mrs. Pop,

      That's a smart approach that I've heard of other people taking: kind of having different buckets of money (& AAs) set aside for different time periods of retirement. Seems like an effective way to diversify assets as well as approaches.

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  9. When I previously commented about your asset allocation, I didn't realize you were planning to retire in roughly 8 years. There are basically 4 schools of thought on asset allocation in retirement.

    1. Keep your asset allocation (AA) stocks/bonds and withdraw from your portfolio as needed.
    2. Use a “buckets” approach pioneered by Harold Evensky in the early 1980s.
    3. Sell stocks first, and then sell bonds as needed. This will reduce the volatility of your portfolio over time.
    4. Sell bonds first, and then sell stocks as needed. This withdrawal strategy is not for the faint-of-heart.

    The latter is what Michael Kitces advocates. This strategy originated with a paper by Robert Weigand and Robert Irons called, “When Does a Bonds-First Withdrawal Sequence Extend Portfolio Longevity?,” Journal of Financial Planning; Nov/Dec 2008, Vol. 21 Issue 11, p66.

    I wrote more about this on my blog in a 3 part series Withdrawal Strategies in Retirement

    Another source for withdrawal strategies in retirement is Dr. Wade Pfau. He has a blog at http://wpfau.blogspot.com/ His September 25 post looks interesting in the context of your post. It is titled, "Reducing Retirement Risk with a Rising Equity Glidepath." The post has a link to a paper by the same name that he wrote with, you guessed it, Michael Kitces. The post also has a video in which Wade describes this approach on asset allocation during retirement. (There's some bogus background music that you will just have to ignore.) Wade has written other papers discussing using SPIAs to increase portfolio longevity. He alludes to one of those in the video.

    I hope this helps.

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    1. Thanks so much for the informative reply, Bryce! I was hoping you might read & comment. There is so much good information there...though I wish some of it weren't exactly contrary. As usual, the truth is sometimes muddled and points to the fact that we don't have a crystal ball.

      I'll be clicking around on those sources you mentioned and hope to get some clarity...if nothing else, maybe a future blog post. Thanks again...you're a wealth of good info.

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    2. A lot of the contradictory information on retirement safe withdrawal rates and asset allocation is because no one can predict the future. You may retire into a golden age of market appreciation, or you may retire into the Great Depression 2. More likely is that the market will bump along the way it does with multiple bear-bull cycles occurring over the course of your retirement. My take on asset allocation is to set it to a moderate allocation over the course of retirement, and rebalance by withdrawing from the asset that is above my desired allocation. I will also keep an eye on tax repercussions as well. This may not be the optimal withdrawal strategy, but it won't be as scary in down markets, either. My expectation is that my wife and I will be able to retire in 9 or 10 years using just a 2.8% withdrawal rate. That rate is low enough that we should not have to touch the principal, and will be able to leave a large inheritance to boot.

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    3. Thanks for the explanation, especially on the different strategies. In makes sense: depending on your assumptions, different models will come out as optimal.

      I'm really impressed with your 2.8% withdrawal rate. That's awesome, and shows how well you and your wife have saved & managed spending. Congrats & all the best on your upcoming retirement!

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  10. Have you thought of some mid caps in your allocation? People often overlook them but they are the sweet spots in the market.

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    1. Hi Charles,

      We haven't, only because we picked our asset allocation out of the intro of Bernstein's book, The Intelligent Asset Allocator. It sounded good to us and just kind of ran with it, but we haven't considered tinkering our AA just yet. I can see how that's a bit of a gap in the portfolio though.

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  11. Hey Done by Forty:
    THe only real way to determin the right asset allocation is to stick to the current allocation you have right now, and then adjust it when you reach 40 aka retirement. Then you can probably gauge the market scene to take advantage of what's cheap to futher increase gains. Obviously you can never decrease equities to a level that will affect your retirement drawdown.

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    1. Hi EL,

      Yeah, that's the rub: how you handle equities. There's an ongoing balancing act between wanting to manage risk and from being so conservative that you run out of money later on. I think in the absence of a really slick plan, we will probably continue using our current Simpleton's Portfolio while we gather more research.

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  12. Hey DBF, great post and a good question. Personally we're following a value averaging investment plan so our asset allocation will vary depending on how the market return compares to our expected return. If the market is high vs our expected return then we'll shift more into bonds. If the market is low, then we'll shift more into equities. Overall our goal is to live off the dividends from the equity portion of our portfolio which should average around 80% of our overall savings.

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    1. That's a strategy that I hadn't heard of before but I like the approach: seems like a way of constantly rebalancing to buy low, sell high.

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  13. While we're still paying off debt, we're in a fairly aggressive asset allocation (reflects my aggressiveness, but accounts for Dad's less aggressive nature). Until that debt is paid off, we're not retiring anytime soon, so might as well assume the "normal" retirement, but as we pay off debt, we're probably going to slowly shift to 60% stocks, 40% bonds - which is about as "safe" as I can stand.

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    1. That sounds like a solid strategy. Getting too "safe" has its own (dire) dangers.

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