Traditional wisdom has long held that, as people age and their time horizons shorten, they should reduce their equity exposure and increase their fixed income exposure. There’s even a popular rule of thumb based on this strategy; subtract your age from 100 and that is how much equity you should hold.
Generally, we call this a ‘declining equity glide path’. However, in recent years a new idea has emerged that flies in the face of traditional; do the opposite.
The Rising Equity Glide Path
a) According to Wade Pfau, professor of retirement income at The American College, a declining equity glide path (i.e. reducing your equity component as you grow older) still makes sense when approaching retirement
b) However, once in retirement he advises steadily increasing your equity exposure – i.e. adopting a rising equity glide path
How could this possibly be a good idea?
a) The rationale for this strategy is based on the realization that a stock portfolio is most vulnerable to swings in stock value during the ‘retirement risk zone’ years; the portfolio will be at its largest at this point and a large percentage swing in the market translates through to a large swing in the absolute value of the portfolio
b) This approach essentially recognizes the risks inherent in a disadvantageous ‘sequence of returns’ and looks to mitigate it by including the least amount of stocks when the portfolio is most vulnerable
c) “It helps you in the worst-case scenario [where markets decline substantially in the early years of retirement]…but it doesn’t threaten the ability for you to meet your spending goals in better environments, where the markets do well early in retirement and then do worse later on,” said Pfau.
And on the other hand…
a) There are many who are skeptical of this approach. Dirk Cotton, a financial planner and blogger at The Retirement Café, takes issue with the notion of glide paths altogether. “I think that the rational thing to do is every year to look at how much money you have, look at what your expected expenses are, consider your risk tolerance and your risk capacity – your risk capacity is going to include things like how much of a floor you have,” he said. “And how much savings you have. And you set your asset allocation primarily based on that”
Although more research is definitely needed –as Pfau states – the idea of a U-shaped equity glide path with higher equity in the early years and later years but lower equity content in the years surrounding initial retirement, is extraordinarily fascinating. It flies in the face of established financial wisdom but carries with it a non-intuitive logic that is difficult to refute.
Here at TCPW, our position is that this concept can only work based on a “goals approach” to financial and investment planning. It must be individualized.
That is: What do you want, When do you want it and for how long? Only once these basic questions are answered can an appropriate – strategic and tactical – asset allocation be recommended – to achieve those personal financial goals.