The income-focused allocation delivers similar initial spending to the wealth-focused allocations. Moreover, it does so with a lower failure rate—a lower probability of running out of assets during retirement. From this simple table, we can address three common myths about retirement investing.
Myth No. 1: Short-term bonds are safer than long-maturity bonds.
Reality: Short-term bonds may actually be riskier when retirement income is the goal.
Consider the wealth-focused allocation with a 25% landing point and its income-focused counterpart. The only difference is the composition of their fixed income sleeves. The wealth-focused allocation holds short-term, nominal bonds, while the income-focused allocation holds an LDI portfolio of inflation-indexed bonds.4
Comparing those 25% landing point allocations, the income-focused allocation has higher spending at all percentiles shown in Exhibit 2. The failure rate of the income-focused strategy is also lower. From the perspective of a retirement investor, the LDI bond portfolio appears less risky than short-term, nominal bonds. Why, then, does this myth persist?
The confusion stems from the definition of risk. When measuring risk using price volatility, the LDI portfolio is indeed more volatile because the LDI portfolio seeks to match the duration (interest rate sensitivity) of the future retirement payments. Since retirement payments occur over a long period, the LDI portfolio will typically have a long duration. When interest rates change, large price fluctuations can occur.
However, when measuring risk in terms of retirement income, the LDI portfolio is less risky. The intuition is simple. If an investor must meet a $25,000 liability in 10 years, a bond that pays $25,000 in 10 years is the relevant risk-free asset. No matter how much the bond’s market value fluctuates in the interim, an investor who holds the bond to maturity will successfully meet her liability. This is the concept at the core of LDI.
Myth No. 2: A glide path with a higher equity landing point leads to higher retirement income.
Reality: A higher equity landing point increases the dispersion of outcomes and does not always lead to more income.
Compare the two wealth-focused allocations. The only difference is their equity exposure. The 25% landing point allocation provides similar income to the 50% landing point allocation, except at the 90th percentile.
To see why, remember that in Exhibit 2, spending is proportional to the account balance at retirement. In the paper, we find that median assets at retirement are $1,051,940 and $1,021,311, respectively, for the 50% and 25% landing point allocations. Even though the 50% landing point allocation has higher exposure to equities between ages 45 and 65, initial retirement assets are only slightly higher.
A high equity landing point does not generally lead to better outcomes. Median initial income is no higher, and the higher equity exposure during retirement does not help sustain spending. In fact, the allocation with a 50% landing point has the highest failure rate; for investors interested in smooth retirement consumption, transitioning toward a moderate exposure to equities as they approach retirement may be a better alternative.
Myth No. 3: Higher equity exposure in retirement can help manage longevity risk.
Reality: Proper planning, solid risk management, and annuity income can help manage longevity risk.
In the US, the conditional life expectancy at 65 is 21 years for women and 18 for men.5 Therefore, the 30-year retirement shown in Exhibit 2 corresponds to a high-longevity scenario. Yet the allocation with the highest equity exposure in retirement has the highest failure rate. The income-focused allocation, which addresses market, interest rate, and inflation risk, has the highest chance of supporting retirement consumption until age 95.
High equity exposure in retirement is risky and may be unnecessary for many investors. Retirement investors likely have more control over their savings and spending behavior, which can be more reliable tools to address longevity risk. Annuities, which are specifically designed to manage longevity risk, are another option. For example, US investors can delay Social Security until 70 and replace the income they would normally receive by increasing spending from their own assets during the first five years of retirement.6 The initial Social Security payment is then increased, and this higher payment amount is the baseline to which cost-of-living adjustments are applied; payments are thus higher for life. The transaction is equivalent to buying additional amounts of an inflation-indexed annuity backed by the US government.7 All those avenues may be more sensible ways to address longevity risk without doubling down on stock market risk.
Stay tuned for the next blog post of the series, which will look at the performance of different retirement strategies in difficult market environments.