One of the most vexing issues facing retirees is deciding on an asset allocation and withdrawal rate that minimize risk of eventually running out of money. Conventional wisdom suggests that over time you should steadily decrease the percentage stocks in your portfolio. A well-known rule of thumb is to subtract your age from 100 and that is the percentage to allocate to stocks (i.e. a 30 year-old would invest 70% in stocks and 30% in bonds while an 80 Year Old would invest 20% in stocks and 80% in bonds).
However a recent study by Wade Pfau and Michael Kitces, “Reducing Retirement Risk with a Rising Equity Glide Path” suggests that the conventional wisdom might be wrong (at least during the retirement years). They compared the results of a steadily increasing exposure to stocks during retirement, keeping the allocation constant and steadily decreasing the exposure to stocks. They found that the strategy that did the best job of minimizing the risk of running out of money was to start retirement with a low percentage of stocks (something like 30%) but then steadily increase that percentage during retirement (to approximately 60%).
This seems counterintuitive but upon further analysis it makes sense. A lot of the risk related to making your retirement portfolio last through your lifetime has to do with the timing of stock market declines. If you encounter a big stock market decline early in your retirement the impact can be significant. It might take years to make back what was lost in that early period. In the meantime you’ll have to lower your withdrawal rate. However, if the stock market performs well during your early years of retirement you’ll likely be so far ahead of your projections that running out of money is no longer a factor even if a big decline happens later.
Thus, if you start with a low percentage of stocks and encounter a big decline early you will have minimized the impact of the decline. As you increase the percentage of stocks going forward you’ll take advantage of the market recovery. On the other hand if the market does well early in your retirement you can safely take on the additional risk in the later years.