Updated Tuesday, July 22, 2014 as of 1:29 PM ET
Should Retiree Clients Boost Equity Exposure?
Monday, May 5, 2014
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MIAMI -- Have you been giving retiree clients bad advice?

Conventional wisdom holds that portfolio allocations should become more conservative as investors live into their retirement years, decreasing clients' exposure to equities.

But recent research from Michael Kitces, partner and director of research at Pinnacle Advisory Group, and Wade Pfau, professor at The American College, indicates that gradually increasing equity exposure can significantly benefit clients' portfolios, particularly in terms of managing for the downside of sequence risk.

Traditional decreases in equity exposure can exacerbate the negative consequences of severe or extended down markets that occur at the wrong time for soon-to-retire investors, Kitces told planners at the annual FPA Retreat conference here this weekend as he presented the research. 

Instead, their findings suggest that clients should enter retirement with a more conservative allocation to equities -- say, 30%, rather than the more traditional 60% -- and then slowly increase that over the retirement years.

'BUCKET' APPROACH INSUFFICIENT?

A traditional "bucket" approach calls for dividing client assets into three buckets, Kitces explained: a near-term one that holds cash, a second for intermediate-term expenses, which holds mostly fixed income, and finally one for the long term that holds equities.

Planners may also take an annuitization approach, converting part of the portfolio into a stream of income with the remainder invested in equities, Kitces said.

After noticing that partial annuitization of retiree portfolios over time led to increased equity exposure and better returns, Kitces and Pfau decided to dig into the numbers to understand why the annuity approach led to superior results for retirees.

Controlling for the partial annuitization, the pair studied the impact of an increasing equity glidepath in retirement, asking the question: What if the portfolio matched the same glidepath as the annuitization strategy, but without the annuity?

While it may seem counterintuitive, the duo's findings suggest that gradually increasing equity exposure over a 30-year period to 60% or 70% could result in superior returns and a higher probability of success in retirement than with a static or decreasing equity allocation.

"If equities are wonderful in early years, the only impact is on how much you leave to the kids, whether it's septuple or only quintuple your wealth," Kitces said. On the other hand, he added, if the market is down, this approach could help mitigate losses and then allow for greater upside potential during a stock market recovery.

IMPLICATIONS FOR ADVISORS

Kitces and Pfau's research found that a portfolio that started at 30% equities and finished at 70% equities would have a 95.1% probability of success, using historical returns. The analysis assumed an average annual compound real growth rate of 6.5% for stocks and 2.4% for bonds, and a 4% withdrawal rate approach.

This means equity exposure is high when the client is young, lower when the portfolio is big and then higher again in the retirement years, he said. And although it seems to go against what advisors have long told clients -- and what clients may feel comfortable doing -- this approach is actually more conservative, Kitces argued.

While the portfolio may end up with a 60%-70% allocation to equities, if the glidepath gradually inches up from 30% to 60% exposure to equities over 30 years, you actually have an average allocation over time of only 45% to equities, according to Kitces. "The general gist is that you gradually increase equity exposure over the client's lifetime," Kitces said. Kitces and Pfau are still looking at when it's most advantageous to cut off the increasing glidepath.

But the approach may not work for everyone. Here a few other issues Kitces said advisors should consider:

-What is the ultimate goal of retirement? Is it maximizing wealth and inheritance, maximizing success or ensuring that a minimum goal is achieved?

-Will retirees really be willing to increase equity exposure through retirement?

Ultimately, he said, the increasing glidepath is probably best for clients in the middle -- those that don't have so much that this tactic is insignificant nor those that have so little they may need to put "as much into equities as they can tolerate and pray."

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