Should retirees hold on to equities? Not necessarily

Retirees receive surprisingly little benefit by dramatically increasing their equitySPX, -0.88%  exposure.

That is the conclusion I draw from a recent analysis of retirement finances by financial planner, actuary and retirement researcher Joe Tomlinson.

After analyzing a number of different retirement funding scenarios, he found that shifting equity allocation from 50% to 75% increased the present value of a retiree’s total spending in retirement by less than 2%.

The reason this result is so surprising: Retirees have been told over and over again that they must have a healthy allocation to equities if they are to stand any chance of retiring with the standard of living to which they’ve grown accustomed.

This is especially the case for the many retirees who have inadequately funded their retirement.

Tomlinson’s analysis, which was published recently week by Advisor Perspectives, is heavily dependent on the assumptions he made.

But his seem entirely reasonable.

For example, he assumed that bonds would produce an annualized average return of 0.75% above inflation, and that stocks would beat inflation by an average of 5% per year.

If anything, given that stocks are by many measures quite overvalued today, you could argue that he was being too generous in his assumption of how stocks will perform over the next couple of decades.

And yet, even so, the retiree’s benefit from increasing his equity allocation was very modest.

Tomlinson focused on a couple both of whom currently are about to retire, and who have an un-mortgaged house and sizeable retirement savings.

He assumes that they defer Social Security until age 70, borrowing against their savings to live on until then.

He further assumes that they use some of their savings to purchase an annuity, and that they also convert the equity in their house, via a reverse mortgage, into a guaranteed monthly payment.

Together, these two moves make up the gap between their Social Security income and the bare essentials of what this couple needs to live on.

With the remainder of their savings this couple invests in a combination of stocks and bonds, withdrawing each year the required minimum distribution.

To be sure, it makes a big difference the order in which stocks’ and bonds’ good and bad years occur during retirement—something known as sequence risk.

Another source of uncertainty is that the couple can’t know how long they will live—something known as longevity risk. To reflect the various possibilities,

Tomlinson ran 5,000 simulations that varied the ages at which the retirees died and the order of good and bad years.

He presented his conclusions by focusing on the median outcome—the one for which half the simulations performed better and half performed worse.

Given these assumptions, Tomlinson found that shifting portfolio allocation from 50% stocks/50% bonds to 75% stocks/25% bonds led to an increase of 1.98% in the net present value of the couples’ total spending in retirement.

To be sure, it led to an increase of 18% in the value of their estate after both of them die; the reason this larger estate didn’t translate into more spending is that the couple didn’t know when they would die and therefore needed to ration out the amount spent each year.

Increasing the equity allocation also had a downside. To show this, Tomlinson focused on the simulation that was at the fifth percentile of the outcomes.

Increasing the equity allocation from 50% to 75% decreased the net present value of the 5th percentile outcome by 1.6%.

So there definitely is a tradeoff to increasing equity allocations.

Tomlinson’s results illustrate, once again, the importance of focusing on the things that really matter in retirement. And, at least given the set of assumptions Tomlinson employed in his simulations, there are many retirement planning decisions that are far more important than how much of savings get allocated to the stock market.

It’s possible to quibble with Tomlinson’s assumptions.

Some may object to assuming the hypothetical couple used a big portion of their retirement savings to purchase an annuity.

But that is hardly objectionable.

As I reported in a Retirement Weekly column last November, David Blanchett, head of retirement research at Morningstar, found from running more than 78,000 different retirement scenarios that the average optimal allocation to an annuity was 30.52%.

The allocation assumed by Tomlinson’s hypothetical couple was only moderately larger than that average.

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