How can retirees allocate assets to support their consumption, even in challenging times? A previous post, based on our recent research paper, discussed how an income-focused asset allocation can generate similar retirement income to a wealth-focused allocation while offering better risk management. Those results were based on simulations including both good and bad scenarios.1 We now focus on performance in three bad scenarios: poor stock market returns, increases in inflation, and decreases in interest rates.
We consider an investor who starts making regular contributions to a retirement account at age 25 and who retires at age 65. At 65, the investor plans for a 30-year retirement and spends the same amount (adjusted for inflation) every year. We look at two allocations: a wealth-focused allocation with a high equity landing point (50%) and an income-focused allocation with a moderate equity landing point (25%).2 Exhibit 1 shows the equity percentage for the allocations at different ages. The wealth-focused allocation invests the remaining assets in short-term, nominal bonds, while the income-focused strategy invests in a liability-driven investment (LDI) portfolio of inflation-indexed bonds.
To Retirement and Beyond: Asset Allocations Over the Life Cycle
Our results are based on 100,000 simulations. Bad scenarios are defined as the worst 10% of these simulations, based on the economic environment in the first five years of retirement, as defined below. Each condition leads to a different set of 10,000 simulations.
- Lowest average stock market returns. Poor stock market returns, especially when combined with fixed withdrawals, can cause the investor to run out of assets early.
- Largest unexpected increase in inflation. An unexpected increase in inflation reduces the real returns on nominal bonds.
- Largest unexpected decrease in interest rates, defined as a parallel shift of the yield curve. A drop in interest rates leads to a capital gain on existing bond positions, while reducing expected returns. Lower expected returns can reduce the ability of the portfolio to meet future liabilities.
Exhibit 2 shows the probability of running out of assets by age 85 and 95 under the two allocations. In Panel A, the failure rate at 85 is 5.7% for the wealth-focused allocation, compared to 0.1% for the income-focused allocation. When stock market returns are poor early in retirement, the failure rate for the wealth-focused allocation is a much higher 33.7%. Our hypothetical investor now has a one-third probability of running out of assets 20 years into retirement, even though she initially planned for a 30-year stream of income. By contrast, the failure rate on the income-focused allocation would be a mere 1.2%, even amid those low stock market returns.
Inflation and interest-rate surprises matter too. While the failure rate is 5.7% in all simulations, it is 8.4% in simulations with a large inflation increase and 7.2% in simulations with a large interest rate drop. The failure rate of the income-focused allocation remains 0.1% in both of these “bad” scenarios. This is a direct benefit of the liability-driven approach to fixed income, which seeks to immunize the income that the portfolio can support from changes in interest rates and inflation.
Turning our attention to the high-longevity scenario in Panel B, we see that the baseline failure rates at age 95 for the wealth-focused and income-focused allocations are 30.1% and 20.2%, respectively. Narrowing to the worst 10% of outcomes, the failure rate for the wealth-focused allocation is 36.3% in the subset tied to inflation increases and 35.3% in the subset linked to interest rate drops. Again, failure rates for the income-focused allocation are not higher in bad inflation or interest-rate scenarios. Finally, the failure rate for both allocations is very high when stock market returns in the first five years of retirement are in the worst 10% of possible outcomes. Yet when the income-focused allocation runs out of assets, it is more likely to do so near the end of retirement, while the wealth-focused allocation has a significant chance of failing within 20 years (as shown in Panel A).
Our results suggest that, while not bulletproof, an income-focused allocation offers strong risk management even under adverse economic conditions. This downside protection can be attractive to retirees in its own right, but it is especially valuable to workers who are forced to retire early. Workers may have to retire early for both personal reasons (such as health issues) or because of poor economic conditions (if mass layoffs occur, for instance). In these circumstances, downside risk management is especially important: having one’s retirement readiness derailed right after being laid off can have life-altering consequences. An income-focused allocation can help retirees stay on a sound financial footing in challenging times—and have greater confidence when times are good.
This article is the second of a two-part series. The first installment, Researching Retirement: Myths and Realities About Asset Allocations, looks at how an income-focused asset allocation may deliver similar retirement income to other common approaches while better managing risk.
A liability-driven investment (LDI) strategy is designed to focus on assets that match future liabilities. LDI strategies contain certain risks that prospective investors should evaluate and understand prior to making a decision to invest. These risks may include, but are not limited to, interest rate risk, counterparty risk, liquidity risk, and leverage risk.
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