Market Mini: The Importance of Allocating Your Assets to Ensure Enough Money in Retirement

Posted By on Dec 6, 2013|0 comments

With market exuberance pushing the market higher, companies like Twitter issuing stock when they lack earnings and Snapchat declining an offer of $3 billion dollars from Facebook, it is timely to review withdrawal and savings rates based on asset allocations.

For this I turned to Wade D. Pfau, Ph.D., CFA, and his work “Withdrawal Rates, Savings Rates, and Valuation-Based Asset Allocation” in the Journal of Financial Planning.

Because the stock market is up over 25% year to date, investors may squirm at the idea of lowering their stock exposure for bonds; however, this is exactly what Pfau’s research advocates.

Many investors and financial advisors alike would find missing out on returns to be emotionally difficult; however, as Pfau elaborates in his literary review, stock markets are mean reverting. Specifically, when the Cyclically Adjusted Stock Earnings Ratio (CAPE), otherwise known as PE10, is high, markets tend to decline and provide relatively lower returns than expected and vice versa. It is called PE10 because the current price of the stock market is compared to the average of corporate earnings in the last 10 years.

The timing is difficult to adjust and individuals can expect the stock market to increase significantly at times before a decline occurs. As a result, individuals often believe that they are missing the “train” of strong returns. As Pfau states “This research is indeed grounded in the notion that attempting to beat the market in the short run is futile. It can take years for mean reversion to happen, but can patient clients find a strategy to take advantage of this mean reversion in market valuation levels?”

The strategy Pfau uses is inspired by Graham and Dodd’s book Security Analysis. A 50/50 stock/bond portfolio is compared to stock allocation of 25, 50, or 75 percent and is determined by the value of the PE10 with respect to its historical range.

Adjusting a portfolio based on valuation PE10 at the beginning of each year, Pfau found that withdrawal rates over a 30-year period exceeded two percentage points throughout the time. The valuation-based strategy offers a lower savings rate at every point in history.

There were two years out of the 139 rolling periods used that provided lower withdrawal rates. Individuals who retired in 1979 and 1980 saw lower withdrawal rates due to exuberant markets in the late 1990s.

I found Pfau’s additional research on what happens when individuals change their asset allocation in the opposite direction very important. His research discussed what happens if an investor chose to follow momentum, thereby increasing stock exposure when stocks markets increased in value. The conclusion ultimately led to poor returns and withdrawal rates. As Pfau states “This strategy lowers sustainable withdrawal rates compared with a fixed 50/50 allocation in all years except 1980. Clients clearly would have been harmed historically by having their emotions lead them towards the non-valuation-based direction away from their strategic asset allocation.”

While dollar-wise and statistically better, Pfau’s approach is difficult to implement. When the market is roaring higher, investor’s emotions are difficult for financial advisors to adjust to. The beat of a siren call of a higher market is hard to avoid for many investors. I personally have seen withdrawals of over $150 million in assets for people wanting to move from a valuation-based strategy to a momentum strategy of increasing stock exposure as market value increases.

Unfortunately, these investors face what Michael Kitces calls a “sequence risk.” This is when an investor’s wealth is at the mercy of the stock market and declines, which ultimately creates lower wealth and results in lower withdrawal rates.

Despite the difficulty in dealing with the emotional impact from investors and the risk of losing assets and lowering revenue, Pfau provides a good case for why financial advisors should incorporate a valuation approach to asset allocation in order to help clients increase wealth and provide higher withdrawal rates in retirement.

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