Improving the Conventional Retirement Glidepath

Are there easily implementable life cycle investing strategies reliably superior to the conventional glidepath from equities toward bonds? In their June 2013 paper entitled “The Glidepath Illusion… and Potential Solutions”, flagged by a subscriber, Robert Arnott, Katrina Sherrerd and Lillian Wu summarize flaws in the conventional glidepath approach and explore simple alternatives that address some of the flaws. Specifically, they compare the follow six strategies:

1. 80–>20: the conventional linear glidepath from 80% stocks-20% bonds to 20% stocks-80% bonds at retirement, with market capitalization weighting.
2. 20–>80: inverse of the conventional linear glidepath.
3. 50-50: constant 50% stocks-50% bonds, with market capitalization weighting.
4. Dynamic Bond Duration: the 50-50 strategy, but: (a) hold 20-year bonds for the first 21 years; (b) shift linearly to 10-year bonds during the next ten years; and, (c) shift linearly from 10-year bonds to T-bills during the last 10 years before retirement.
5. Dynamic Value/Low Beta: the 50-50 strategy, but: (a) stocks are weighted by book value for the first 21 years (from the 1,000 U.S. stocks with the highest book value); and, (b) shift linearly to low-volatility stocks (the 1,000 largest U.S. companies by market capitalization, weighted by inverse volatility) during the next 20 years.
6. Dynamic Combined: the 50-50 strategy, but use Dynamic Bond Duration and Dynamic Value/Low Beta for bonds and stocks, respectively.

Comparison tests assume that: (1) each individual makes inflation-adjusted $1,000 annual contributions to a retirement portfolio over a 41-year career; and, (2) portfolio rebalancing is annual, frictionless and tax-free. Using simulations based on long-term samples of U.S. stock index, bond index and U.S. Treasury bill (T-bill) returns through the end of 2011, they find that:

• Flaws in the conventional 80–>20 strategy include:
  • Capitalization-weighted equity indexes tend to overweight overpriced stocks and underweight underpriced stocks, thereby creating a drag on future performance.
  • Retirement portfolio utility is better measured by expected retirement income (real annuity value) than terminal portfolio value at retirement .
  • Inflation and interest rate jolts hurt stocks and bonds. Adding inflation hedges (such as TIPS) to retirement portfolios, weighted according to inflation expectation, reduces uncertainty in retirement outcome.
  • The relationship between risk and reward is not linear.
• Specifically, for the first three strategies above during 1871 through 2011:
  • The first (last) individual starts working at the beginning of 1871 (1971) and retires at the end of 1911 (2011), for a total of 101 investment experiences.
  • On a dollar-weighted basis, 80–>20 tilts relatively toward bonds because the portfolio is small (large) when equity-centric early in life (bond-centric late in life).
  • The conventional 80–>20 underperforms 20–>80 and 50-50 based on both terminal value, real annuity value and most other performance metrics.
• Adjusting the riskiness within stock and bond portfolios over time improves performance. For example, for the six strategies above during during 1927 through 2011 (see the chart below):
  • The first (last) individual starts working at the beginning of 1927 (1971) and retires at the end of 1967 (2011), for a total of 45 investment experiences.
  • Incorporating Dynamic Bond Duration lowers the variability (uncertainty) in the gross terminal annuity value.
  • Incorporating Dynamic Value/Low Beta for stocks increases gross terminal value and gross terminal annuity value and improves crash protection, without elevating uncertainty.
  • Combining Dynamic Bond Duration and Dynamic Value/Low Beta increases up-side potential, reduces uncertainty and improves crash protection.

The following chart, constructed from data in the paper, compares the average gross terminal values and gross terminal annuity values of the six life cycle strategies above during January 1927 through December 2011. Results suggest that the Dynamic Value/Low-Beta and the Dynamic Combined strategies are the best of the six alternatives, and that the conventional 80–>20 glidepath is close to the worst. Consideration of outcome variability favors Dynamic Combined.

In summary, evidence suggests that there are better ways to achieve financial goals for retirement than the conventional stocks-to-bonds glidepath.

Cautions regarding findings include:

• Asset class returns are for indexes rather than tradable assets. Including costs of creating and maintaining tracking funds for the indexes would lower asset class returns.
• As noted in the paper, results ignore portfolio rebalancing frictions and taxes. Accounting for these costs would adversely affect performance metrics for all alternatives.
• Overall costs may vary by strategy such that the net ranking of alternatives may differ from the gross ranking.

See also “Lifecycle Funds Guard Against Upside Volatility?”, “U-shaped Lifetime Allocation to Stocks?” and “Allocating Assets for Retirement”.