Because actuaries tell us that Polly should live 20 additional years from age 63, it’s much more important to know how large a lifetime inflation-indexed annuity she can buy than to know the size of her nest egg. The second panel of Table 1 shows the average Ending Retirement Real Annuity—an important measure of Polly’s success. On average, by saving $1,000 per year, indexed to inflation, history suggests that she should expect to have a retirement portfolio that will pay her $7,730 per year for life, also indexed to inflation. Sounds anemic… but then again she was only saving $1,000 per year. Unfortunately, again, there’s a big range. Over the past 141 years, she and her counterparts from past generations could have retired on anywhere from $2,390 to $13,130 per year.
If the Glidepath doesn’t lead to greater retirement assets, perhaps it at least provides Polly with more “visibility” into her likely retirement income, a few years before she retires, because the allocation is becoming far less aggressive (another argument advanced in favor of a Glidepath solution). If this transparency were true, people could plan their retirements with greater confidence. Looking at the last panel of Table 1, we can see that Polly’s annuity at age 63 is 154% larger than it would have been at 53. This is partly because the portfolio nearly doubles in size in that last decade and because she can buy a richer annuity with 20 years’ life expectancy than with 30 years. Unfortunately for Polly, the higher expected annuity is associated with considerable variability around that outcome. Her annuity at age 63 could be 54% less or 1302% greater at 53; the 10th percentile shows almost no change from age 53. This is basically the situation for those who turned 63 in 2011; they could have retired with roughly the same lifetime inflation indexed annuity at age 53 as they would now be able to buy at age 63. Sad, but true.2
What’s the Alternative?
So, the Glidepath strategy gives us a pretty uncertain retirement nest egg after 40 years of careful savings, with a pretty uncertain spending stream. Even as retirement looms near, it doesn’t give us much confidence about our retirement prospects or lifestyle. So what? Markets are uncertain. At least we can have more confidence and a safer outcome by ramping down our risk late in life than by any other plan, right? Not true.
Consider another investor, Balanced Burt, who is uncomfortable choosing between equities and bonds and thus decides to maintain a steady course at 50/50, for life. Looking at Table 1, we see that Burt winds up with an average outcome that is 10% better than Polly’s, with an average portfolio of $137,870 (versus $124,460) and an average annuity of $8,550 (versus $7,730). In addition, his worst case is better than hers, as is his 10th percentile outcome, and median outcome; only the single best outcome doesn’t improve in portfolio value, but even that outcome improves in the annuity that he can buy. It is no surprise that Burt’s final 10-year change in retirement income becomes less stable than Polly’s; he is finishing his career with more money in the riskier market. The ratio between 10th and 90th percentile outcome jumps from a 3.5 ratio for Polly to a 3.9 ratio for Burt. This improvement happens entirely from the best outcomes getting better; the worst outcomes do not get worse!
Now consider another investor, Contrary Connie, who is skeptical of the standard retirement strategies—either a balanced portfolio or a Glidepath approach. Connie rationalizes that if a static 50/50 strategy is better than a Glidepath strategy, an Inverse-Glidepath strategy might be more appropriate for meeting her goals than either of the “standard” options. It should come as no surprise that this counterintuitive strategy beats a static 50/50 portfolio by essentially the same margin that static 50/50 beats Glidepath. Contrary Connie beats Prudent Polly by ramping up her risk late in life when the portfolio is already large. Connie finishes with an average portfolio of $152,060, versus Polly’s $124,460. Connie’s worst, median, and best outcomes all trump Polly’s. Connie has to accept more uncertainty late in life as to how much she can spend in retirement—but it’s upside uncertainty!
Critics may argue—correctly—that past is not prologue. This outcome is presumably due to higher real returns for stocks and bonds later in the 141-year period (for example, during the immense bull market from 1982 through 1999), leading to a slight tendency for investors to benefit from ramping up risk later rather than earlier in life. To address this criticism, we put the 141-year history into a lottery, with each year’s returns randomly drawn. It delivers the same relative ranking for the merits of Glidepath versus static 50/50 versus Inverse-Glidepath. The inverse finishes on top again!3
Note, if we systematically replace equities with bonds every year so that we are a 50/50 investor at the midpoint of our career, our returns will fall into the same return distribution, over time, whichever path we pursue. Our average allocation will be 50/50 in all three cases! Markets certainly don’t care about our Glidepath, so we’re as likely to have our best stock market returns late in our career as early. If the best stock market returns come early, it’s self-evident that we’ll finish richer with a Glidepath strategy. And, if the best stock market returns come late in our career, we’ll do well to ramp our risk up as our career evolves. But, in our 20s, how can we know whether stock returns will be better early or late in our careers?
Past Is Not Prologue
We’ve written extensively about the “3-D Hurricane” that’s bearing down on us, about the importance of ratcheting down return expectations in a world of lower yields, and about the perils of extrapolating the past in order to shape future expectations. Much of this work has proven to be very relevant to investors in recent years. Can we transform this historically rooted test of various formulaic approaches to retirement planning into something that might be relevant today? We probably can.
Rather than hoping for a repeat of the past, with substantial returns earned on a foundation of far higher yields than today’s yields, we should probably shape expectations based on the current outlook. Table 2 seeks to transform the “What if past is prologue?” scenarios of Table 1 to answer a different question: “What if risk in the future resembles risk in the past, but returns in the future are lower to the extent that yields are currently lower than the past norms?” It’s a subtle question, but it’s awfully useful to anyone thinking about setting aside reserves for some future retirement.