Meet Fran

Frugal Fran is a 25-year old investor at the beginning of her career making $40,000 per year.  Financially savvy, she has already started planning for her retirement.  She plans to retire at age 65 and follow an “own your age” policy for her stock/bond mix.  Fran projects a salary increase of 1.5% per year, after inflation.  When she retires, Fran would like to replace 85% of her income with distributions.

According to Fidelity, Fran will need $676,000 to retire based on these assumptions.

Whether or not Fran will be able to achieve these goals and retire comfortably will largely boil down to two variables: how much she can save and the return on her investments.

In their assumptions, Fidelity assumes that Fran will be able to save 6% of her salary in her first year of employment and increase here savings by 1% per year until she hits 12% at age 31.  She will also take advantage of the 3% company match in her 401(k), bringing her total savings rate to 9% initially ramping up to 15% at age 31.

With these assumptions, Fran only needs her portfolio to return an annualized 3.8% per year, after inflation.  Given that stocks and bonds have an annualized real return of 6.5% and 1.9% respectively since 1900, this seems like a very achievable goal.

Of course, Fran isn’t investing over 115 years – just 40.  So her ability to hit her goal will be largely based on the market environment she is born in.

Retirement - Figure 1

We can see, however, that by in large, as long as Fran was born in the last century, there is a good chance she would have hit her goal.  Unfortunately, though, if she was born sometime around 1940, she wouldn’t have hit her goal.  In fact, in the cases Fran failed to hit her goal, she had some pretty significant shortfalls.

Retirement - Figure 2

Looking Under History’s Hood

So what happened between the 1940s and the 1980s that caused this shortfall?  First, bonds started the period with anemic yields (much like today) – reducing short-term expected returns – and went parabolic, sending bond portfolios into significant drawdown.

Retirement - Figure 3Equity also went through its own fair share of drawdowns during the period.  And since inflation risk was the highest priority in the market, fixed income and equities exhibited positive correlations in many sell-offs.

Retirement - Figure 4For some, this might actually be good news: this was a pretty unique environment with generally rising real interest rates and little diversification in the equity market.  How likely is it that we’ll see another similar environment in the next 40 years?

Evaluating the Inputs

The problem is that many of our other assumptions may be highly flawed.

First, Fidelity assumes that Social Security survives in its current form.  According to the Social Security Trustees’ 2014 Annual Report, reserves will be depleted in 2034 unless there is significant reform.  Relying on Social Security payments to be there, in similar size, 40 years from today is far from a certain proposition.

Second, this analysis relies on historical U.S. market returns.  In their paper “Global Stock Markets in the Twentieth Century”, Phillipe Jorion and William N. Goetzmann find strong evidence for survivorship bias in global equity returns, indicating that our return expectations may be significantly inflated.  Put another way: historic U.S. equity performance may be a significant outlier and assuming it will continue in the future is potentially dangerous to our portfolio’s health and our terminal wealth.

Consider the following analysis we did in an another blog post, where we built glide paths assuming returns from different countries around the world.  The U.S. glide path is the 2nd most aggressive (Sweden’s was the most aggressive and Austria’s was the least).

Retirement - Figure 5

Research Affiliates seems to agree with this view, setting their 10-year annualized expected real return for U.S. large-cap equities at a paltry 0.8% as of June 2015.

But perhaps most significantly skewed is our assumption on savings rates.  According to Vanguard, actual savings rates are much, much, much lower than Fidelity’s hypotheticals. While conventional wisdom may say to save in the ballpark of 10% of your salary for retirement, the majority of the population does not listen to that advice.

Retirement - Figure 6

Additionally, Moody’s reports that the savings rate for the 25-34 year old age group is actually negative.  If we ignore our first two concerns and simply adjust our analysis for these more realistic savings rates, we get a very different picture of Fran’s ability to retire.

Retirement - Figure 7

Fran’s odds of hitting her retirement goals are now only 18% instead of the 80% she had before.

The reduction of savings makes Fran more dependent on market returns.  Based on this analysis, the only period Fran would have been able to retire in would have been if she started investing around 1955-1965 and retired around 1995-2005.  Of course, this period was marked by one of the largest rallies in both equities and fixed-income in U.S. history – so crossing our fingers and hoping for this performance again doesn’t seem like a prudent plan.

Why A Tactical Solution Is Beneficial

While Fran may not be able to control the market’s returns, she can control her reaction to them. Let’s assume that instead of holding a passive “own your age” portfolio, Fran embraces a more tactical approach.

Why tactical instead of “own your age” in bonds?

As we have seen, the equity and fixed income market performance varies widely over time. This is also true for the relative risk between the two assets.

Essentially, the “own your age” in bonds glide path assumes that increasing the allocation to bonds decreases the risk, which is generally a desirable hedge against large equity market drawdowns as retirement nears. However, this reduction in risk, as proxied by volatility, is not constant; how much a given increase in bonds decreases the risk has varied considerably throughout history.

Relative Vol

The volatility of equities relative to that of bonds has averaged 2.6x historically, but that value can go through periods of large fluctuations.

Between 1922 and 1957, the relative risk was consistently above the long term average, spiking above 20x in 1932 after the Great Depression, and since 1978, it has generally been at or below the average value.

The amount of diversification available between equities and bonds, as proxied by correlation, has also shifted over time.


There have been extended periods where the correlation between equities and bonds has been positive. Aside from the early 1930s and late 1950s, the generally negative correlation since the Tech Bubble in the late 1990s has been unprecedented. The correlation reached its lowest level of -0.76 in 2012.

Given these two facts, it is no surprise that the volatility of different portfolios along the glide path can change significantly between periods and between portfolios. The graph below shows the realized volatility of three different portfolios Fran has along her glide path:

  • “Just Starting” – 75% equities/25% bonds
  • “Midway” – 55% equities/45% bonds
  • “Retirement” – 35% equities/65% bonds

Indiv vol

From this we can see that Fran gets a wide array of volatility profiles depending on when she is born. A retiring Fran during the beginning of the Great Depression (early 1930s) had more volatility in her portfolio than a Fran did just starting out any time after that point until the Financial Crisis in the late 2000s. In 1982, Fran was taking on approximately the same amount of volatility regardless of where she was along the glide path.

Even though volatility is only a measure of risk, a tactical allocation plan is a great solution for inconsistency in risk exposure throughout time, especially when we look at metrics like drawdowns, which are actually what can hurt Fran more than volatility.

While Fran’s “own your age” in bonds glide path only adapts based on the time Fran has left until retirement, the tactical approach adapts based on the actual market dynamics.

The simplicity of the “own your age” in bonds glide path is appealing in that bonds are generally safer than equities, but Fran can capitalize on opportunities that exist in the market without extending beyond an “appropriate” amount of risk … more on that in a bit.

Putting a Tactical Solution to Work

For the tactical solution, Fran will still follow an “own your age” plan, but will overweight equities by 25% if stocks are above their 12-month moving average and underweight equities by 25% if they are below.  Acknowledging that bear markets in fixed income are also possible, Fran decides that if bonds are below their 12-month moving average, she’ll cut her bond allocation in half and allocate it to cash.

Even with the more realistic savings assumptions, this tactical plan considerably increases Fran’s likelihood of successfully reaching her retirement goals.

Retirement - Figure 8

As we showed before, the “own your age” in bonds glide path has good intentions of reducing risk as Fran ages, but where it misses the mark is setting an allocation based on age. This is simply a rule of thumb, but with an uncertain interest rate environment and high equity valuations, the rules of the retirement game may change rapidly.

Tactically Managing Risk

When discussing retirement portfolios, risk is a key talking point. We looked at the relative volatility of equities and bonds, but when evaluating risk in retirement portfolio, volatility is not always he most relevant gauge of risk. After all, a straight line down, has zero volatility.

In fact, since Fran only cares about the final amount of her portfolio, she can withstand considerably more volatility as she builds her nest egg than she could during the withdrawal phase. (With regular saving, short term dips may even give Fran opportunities to buy low.)

The two most important risks to Fran’s portfolio are:

  1. Drawdowns with a subsequent lock-in of losses, and
  2. Lagging behind the required rate of growth during up-markets

With this in mind, why was the tactical approach so successful at increasing the odds of Fran achieving her retirement goal?

The answer: it protects and participates. And it does so using unemotional rules.

Risk Ignition and Retirement

These rules allow Fran to vary her risk through time based on the market environment without putting pressure on her to decide what she should do.

In his 2011 book, Red Blooded Risk, Aaron Brown discusses a concept called risk ignition. The following quote from the book is a good summary of the idea:

“Taking less risk than is optimal is not safer; it just locks in a worse outcome. In competitive fields, doing less than the best often means failing completely. Taking more risk than is optimal also results in a worse outcome, and often leads to complete disaster.” -Aaron Brown, Red Blooded Risk (2011)

Risk ignition gives Fran another option for improving her retirement outcome. Of course, one option for Fran to increase her odds of success would be to accept retiring on less money; another would be to forego more income during her working life. Saving diligently and having realistic retirement expectations are crucial to building a successful retirement plan, but risk ignition is also a key element of design – one that takes advantage of opportunities in the market without modifying Fran’s end goal or savings plan.

The glide path may prescribe a set level of risk, as indicated by its age-based allocation, but market conditions, and investors’ retirement goals, may dictate otherwise.

By being under-allocated to equities during market rallies, Fran was missing out on growth opportunities when risk was low. By not participating, she was taking too little risk during up markets.

Conversely, when the equity market was declining, being over-allocated to equities was detrimental to capital. By not protecting with bonds or cash, Fran was taking too much risk during down markets.

By using a tactical approach to manage retirement assets, the amount of equity exposure (Fran’s risk dial) can be tailored to the specific market environment. Protecting capital during drawdowns and participating in equity market growth are critical to Fran’s success.

To gauge the amount of participation and protection that Fran gets with a tactical strategy, the following chart shows the average up capture and down capture during up and sown periods for the strategic “Just Starting” (75%/25%), “Midway” (55%/45%), and “Retirement” (35%/65%) portfolio. In this analysis, down periods are defined as the peak to trough period of drawdowns greater than 10% in the strategic portfolios, and up periods are the stretch between the trough and the following peak.

Avg Up and Down Capture

The asymmetric upcature and downcapture profile of the tactical strategy on each portfolio shows how risk ignition is behind Fran’s increased odds of retirement success. Taking less risk during down periods and more risk during up periods move Fran’s realized glide path closer toward the optimal amount of risk, an amount that is more in line with what the market environment dictates and with Fran’s retirement goals.

Will You Be able to Retire Without a Tactical Solution?

A retirement portfolio is constructed with a specific goal in mind: retirement, which is generally at a set date. We have neglected any life events that can affect savings rates and create early withdrawals, but even ignoring these detractors, this analysis has shown that the “average” course of saving and investing for retirement, is not enough to guarantee a successful outcome even a quarter of the time. Imagine how grim these prospects would get if we threw in more kinks in Fran’s plans!

A successful outcome was highly dependent on tactically allocating along a standard glide path.

While a well-diversified, strategic asset allocation should serve as the basis for any investor’s investment policy, most investors do not have the luxury of waiting for asset returns to converge to long-term averages.  Due to limited investment horizons, most individuals and families are largely at the mercy of the market to propel them to their envisioned retirement.  Used in conjunction with traditional risk mitigators (e.g. high quality fixed income), tactical asset management can be a core component of a more robust risk management game plan.  More robust risk management can in turn help investors weather financial storms and keep asset accumulation on the right course to achieve their retirement goals.

Note: Adding the tactical overlay only added an average of 2.5 trades per year – a small price to pay for such a dramatic increase in the odds of achieving retirement goals.

Nathan is a Portfolio Manager at Newfound Research, a quantitative asset manager offering a suite of separately managed accounts and mutual funds. At Newfound, Nathan is responsible for investment research, strategy development, and supporting the portfolio management team. Prior to joining Newfound, he was a chemical engineer at URS, a global engineering firm in the oil, natural gas, and biofuels industry where he was responsible for process simulation development, project economic analysis, and the creation of in-house software. Nathan holds a Master of Science in Computational Finance from Carnegie Mellon University and graduated summa cum laude from Case Western Reserve University with a Bachelor of Science in Chemical Engineering and a minor in Mathematics.