Market Mini: Stock Exposure and Retirement Income – What is the Right Balance?

Posted By on Jan 3, 2014|0 comments


Living the life of a financial advisor can be humbling. The stock market and the future can change on you without reason. The best-laid plans often change because our environment changes. The best we can do is to plan given what we know at the time when we make a decision.

David Blanchett has tried to empower financial advisors with more knowledge in his 2007 work “Dynamic Allocation Strategies for Distribution Portfolios: Determining the Optimal Distribution Glide Path” which appeared in the Journal of Financial Planning in December 2012.

Blanchett looks at different stock exposure and glide paths (change in stock exposure) to see which one is optimal. He also looks at the probability of success as well as the success-to-variability ratio, which compares success to the standard deviation of the portfolio. I thought this was unique and a beneficial addition to the analysis of withdrawal rate.

Blanchett determined that the fixed 100 percent allocations-to-stocks had the best success rate, but that the volatility may prove too risky for some clients to handle. This type of portfolio has nearly seven times the variability (or risk) of the portfolio with 100% in bonds (17.08 percent versus 2.20 percent).

Blanchett stated “high portfolio variability can lead to sleepless nights for clients and may often result in poor investment decisions (exiting the market after a large loss). Therefore, the underlying variability of a portfolio should be considered when selecting the optimal portfolio for a retiree.”

DISTRIBUTION GLIDE PATHS

The reality is that financial planners deal with humans who are emotional and may act differently over time. A client’s reaction to a shift in the market may require a change in plan. Blanchett does a great job of assessing various glide paths and determining which may be best in certain scenarios. While clients will always react differently to different risks, the analysis gives us a better idea of what to recommend.

Blanchett compared five primary glide paths:

  1. Constant: static allocation for the entire period.
  2. Linear: the equity allocation decreases by 1 percent a year throughout the distribution period.
  3. Stair: the equity allocation decreases by 10 percent every ten years throughout the distribution period.
  4. Concave: the equity allocation decreases at an increasing rate and resembles a concave hyperbola throughout the distribution period.
  5. Convex: the equity allocation decreases at a decreasing rate and resembles a convex hyperbola throughout the distribution period.

The conclusion was that the most optimal glide path from a pure probability-of-success perspective was the 100/0 (100 percent stocks and 0 percent bonds) static allocation portfolio, which simply may have too much volatility for a client to handle.

Going to the other extreme, 100% bond portfolios had a great glide path throughout a 20 year period but performed the worst for a glide path over 40 years.

Consequently, the length of time a portfolio needs to survive matters greatly.

For simplicity sake, Blanchett found that “constant (static allocation) distribution glide paths proved to be remarkably efficient distribution strategies, followed by the concave distribution glide path strategy. But in order to determine the true optimal distribution glide path, a variety of factors must be considered.”

Further research can be done in two manners. The first way is varying the portfolio over time based on valuation. The second manner is looking at maximum drawdown versus standard deviation as a measure of risk. This may also help with sequence risk.

What we are left with is the realization that acting as a financial advisor can be difficult as we are dealing with people in an ever-changing environment. The reality is that some portfolios may work better for different clients given their life expectancy, desired income and risk preferences. All these factors must be considered when choosing a portfolio for your clients.

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