Adequate Equity Exposure May Lower the Risk of Outliving Assets

The T. Rowe Price asset-allocation glidepath starts with 90% of investors’ assets in stocks for those more than 25 years from retirement, reduces that to 55% at age 65, 35% at age 80, and 20% at age 95 and thereafter. With more investors concerned about the level of equity exposure in their retirement accounts, T. Rowe Price undertook a new study to reexamine the potential benefits and risks of this asset-allocation strategy. The analysis re-affirms the glidepath’s equity allocations for a diverse set of retirees who do not intend to cash out their assets at retirement but instead seek a stream of retirement income over their life-spans.

In 2005, a 65-year-old couple had more than a 50% chance of one of them living to age 90 and a 23% chance of one of them living to age 95, according to the Society of Actuaries. Retirees also are not only living longer but staying active longer, and that tends to increase their income needs.

One of the key findings of the new simulation study is that if retirees restricted their initial withdrawal to 4% of their nest eggs (and increased each year’s withdrawal amount by 3% for inflation), then even a very conservative, all-fixed-income portfolio would provide a greater than 90% chance of not running out of money during a 30-year retirement.

According to a 2007 survey by the Profitsharing/401(k) Council of America, the average 401(k) participant’s saving rate is only 8.8%, including employer contributions – far less than the 15% savings rate that T. Rowe Price financial planners recommend to replace at least half of the participant’s preretirement income from his portfolio.

Meanwhile, the average withdrawal rate for participants 60 to 69 years old in 401(k) plans managed by
T. Rowe Price is estimated to be more than twice as much as the recommended 4%. Without sufficient equity exposure, retirees’ chances of not outliving their assets would fall sharply at higher withdrawal rates. The new study found that with an all-fixed-income portfolio, the odds of sustaining withdrawals over 30 years would be 70% at a 5% initial withdrawal rate, less than 30% at a 6% withdrawal rate, and virtually 0% at an 8% withdrawal rate.

By contrast, many financial planners say investors should seek a 90% probability of not exhausting their assets. As shown in the chart on page 16, at a 5% withdrawal rate, retirees potentially run the best chance of not running out of money with a portfolio that includes 40% equities – roughly the average allocation of T. Rowe Price’s glidepath over a 30-year-period from ages 65 to 95. With 6% and 8% withdrawal rates, even greater stock allocations are required for better outcomes – though these results still fall far short of a 90% chance of success.

“Because many investors under-save and over-spend, they tend to need help from their portfolios,” Mr. Clark says. “If they saved enough and didn’t withdraw too much, they could stick with a conservative allocation to stocks,” he says. “But if you take into account what investors and retirees tend to actually do, then over the long term the best way to help them is by encouraging them to have adequate exposure to equities.”

The new study also found that adequate equity exposure could potentially provide more purchasing power for retirees – no small matter. For that reason, even those who withdraw only 4% of assets the first year of retirement should consider having a significant equity allocation in their portfolios.

Based on thousands of potential market outcomes, the study examined the median remaining purchasing power for various asset-allocation strategies after 30 years of retirement, based on the inflation-adjusted final balance in the account as a percentage of the initial balance at retirement.

The result: Higher equity allocations generally translated to higher purchasing power. For example, after 30 years of withdrawals a fixed portfolio of 40% stocks and the rest in bonds had a median purchasing power of 131% of the original balance at retirement, while a portfolio of 60% stocks had a median purchasing power of 162% of the original balance. (This assumes a 4% initial withdrawal amount and annual increases for inflation.) Higher ending balances are assets that ultimately could be bequeathed to heirs or used for the all-too-common event of an unexpected medical or other expense arising late in life.

“So, for retirees -- who are not only concerned about having enough to live on for 30 years, but also about having more protection from inflation and about meeting emergency expenses -- maintaining a meaningful equity exposure makes sense,” Mr. Clark says.

At the same time, the principle that more equities tends to result in higher end balances must be tempered by an appreciation for the greater risks of short-term market losses with higher equity allocations. Because of the volatility of equities, the T. Rowe Price glidepath aims to balance potential gains and risks by reducing equity exposure over time.

So, it is designed for higher equity allocations and short-term risks in the first 15 years of retirement (when there remains time to recover from potential losses in stocks) and lower equity allocations and short-term risks in the remaining 15 years (when there is less time to recover from losses and when retirees tend to be more risk averse).

This T. Rowe Price analysis projects thousands of possible market outcomes based on expected returns for various asset classes. A look at actual historical results also supports the findings.

The firm compared three portfolio strategies over actual 30-year periods, starting with the one ending in 1955 through the one ending in 2008 (54 30-year periods in all.) In the vast majority of these periods, investors tended to benefit from adequate equity exposure.

The study compared the ending balances of three portfolios for each period, assuming a starting balance of $1 million and an initial annual withdrawal of 4% (increased annually by the Consumer Price Index for All Urban Consumers).

One of the three portfolios followed the T. Rowe Price asset-allocation glidepath for a 65-year-old retiring with a 30-year horizon. Another was invested according to a more conservative glidepath that had 10% less stocks and 10% more devoted to fixed-income until an equity allocation of 20% was reached. The third portfolio followed an even more conservative glidepath that had 20% less in stocks and 20% more in fixed-income until an equity allocation of 20% was reached.

As might be expected, the standard glidepath – with relatively more stocks than the other two more conservative portfolios – outperformed those two portfolios during the large majority of 30-year periods, providing significantly higher final balances to retirees. However, even in the relatively few 30-year-periods in which markets performed so poorly that the standard glidepath ran out of money prematurely, there were very few times that it significantly underperformed the other portfolios. “In almost every period where the glidepath ran out of money before the end of 30 years, the more conservative glidepaths ran out of money, too,” Mr. Clark says.

For example, during the 30-year period ending in 1998, the T. Rowe Price glidepath ran out of money after the 28th year, as did the portfolio with 10% less in stocks. The portfolio with 20% less in stocks ran dry after 29 years.

“This is because, although more conservative allocations have performed better in below average markets over the shorter term, there has tended to be a very limited range among poor outcomes for longer time periods, such as 30 years,” Mr. Clark says. “There hasn’t been much difference among widely varying asset allocations when markets are so disappointing over long periods.”

That’s not as much the case in stronger stock markets, when stocks have tended to outpace bonds by healthy margins.

“So, long-term exposure to equities has tended to produce more long-term potential upside than more exposure to bonds,” Mr. Clark says, “and it has not tended to produce significantly more long-term downside risk. Of course, past performance cannot guarantee future results.

“There’s no Holy Grail here – your outcomes depend on the market,” he says. “After 2008, many investors may well say they wish they had not had such a high equity allocation because they lost so much money. But if you’re not successful because of bad markets, the alternative approaches – more conservative asset allocations – also tend to be unsuccessful.”

While investors naturally focus on severe losses suffered in a bear market, they often overlook the accumulated gains from equity exposure during the preceding years. Because of those earlier gains, they often may still be better off after a severe bear market than if they had been much more conservatively invested all along. Even with the 2008 bear market, for example, portfolio strategies with larger equity positions over the last 30 years provided higher retirement balances than more conservative portfolios.

“The path to retirement success -- not outliving your assets -- is to save adequately before retirement, then to not over-spend once you reach retirement and to make sure your retirement portfolio has adequate equity exposure over the long term,” Mr. Clark says.