New Trends In Retirement Planning: A Wake-Up Call To Advisors And Their Clients
For years, the vast majority of wealth managers and financial advisors have been following a similar approach to their clients’ investments for retirement and beyond. The conventional wisdom is to start with higher proportions of stocks relative to bonds in the accumulation phase (many years until retirement), reducing that proportion as the client approaches retirement (protection phase) and even more during retirement (decumulation phase, when a portion of the principal is drawn down each year for monthly living costs).
In fact, there are over a trillion dollars invested in these types of “target date” funds and products designed to mimic this approach. On the surface, this seems like a reasonable way to manage retirement assets, as it allows for higher risk and returns when accumulating wealth, while cutting back on that risk later to avoid a large drawdown in wealth at the most inopportune time near or during retirement.
However, a March 2019 paper written by academic experts in the study of retirement planning concludes that this conventional wisdom is far from optimal based on nearly 100 years of market history, and in fact, this target date approach has serious implications for the success of retirement savers. The authors argue there are two main reasons for this:
1. Buy-and-hold portfolios can suffer large drawdowns at any time, so investors are subject to significant “sequence risk,” which they define as “the possibility of bad portfolio returns occurring at the worst possible time, e.g. just before or after retirement.”
2. Because the only way to mitigate this risk in a buy-and-hold portfolio is to shift away from higher-return stocks to lower-return bonds, potential returns are damped, which has an impact on the safe withdrawal rate of the accumulated wealth during retirement.
The study investigates a different way of thinking about the problem by using trend-following/momentum methods to automatically shift allocations from equities to bonds. This is referred to as “time diversification,” because the way the markets evolve over time determines how the stock/bond allocations shift. In the analysis, the authors use a simple 10-month moving average decision rule. In other words, if the equity market’s current price is below the average price of the prior 10 months, the portfolio exits from equities and puts that cash into treasury bills until the market price goes back over the monthly average. The same rule applies to bond allocation.
Clearly, this is a different approach. The conventional approach fixes the initial allocation percentages and, over time, shifts more to bonds from stocks on what is termed a “glidepath.” While this does involve a shift of allocations over time, it is done on a predetermined schedule regardless of what happens in the markets. The trend-following approach, by contrast, seeks to control the magnitude of possible drawdowns by exiting if (and only if) the market is doing poorly according to the 10-month rule. Sometimes this helps a lot, such as during the market crash of 2008-2009, and other times, it causes an unnecessary exit and re-entry, known as a whipsaw. The cost of these false signals is low relative to the real benefit to a client of avoiding the worst-case scenarios that can dramatically impact their retirement assets.
The study provides statistical proof that the trend-following approach offers significant improvements in expected withdrawal rates (up to 50% higher on average compared to the glidepath approach).
While there have been other studies that have examined the empirical evidence in support of trend-following as a risk reduction tool, some going back as far as 200 years, this is the first study that shows how important this approach can be as a way to deal with the real retirement risks faced by clients. As a wealth advisor providing fintech solutions for advisors, I firmly believe, and this paper confirms, that clients could benefit from augmenting traditional asset-based diversification with strategy diversification of this type.
I also contend that clients want their advisors to give them this kind of safety through asset and strategy diversification, but many advisors do not offer that choice. There are two main reasons for this. First, advisors are concerned about firm/career risk if they deviate from the buy-and-hold benchmarks. Second, many have been led to believe that market timing does not work because the market timing used by individual clients has been shown to cause significant underperformance over a full cycle as they overweight exposure near the tops of markets and severely underweight at bottoms. However, trend-following risk management rules act differently by exiting after tops (on the way down) and re-entering after bottoms (on the way back), resulting in higher risk-adjusted returns.
You might have heard the expression “the trend is your friend.” In the context of retirement planning, there is no question that a bad downtrend is your enemy. This enemy can more likely be defeated with a careful defensive risk management approach of the type described here. It is time for the industry to take a serious look at the issue of protecting clients against bad retirement outcomes.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.