*This post is available as a PDF here. *

# Summary

- While valuation-based market timing is notoriously difficult, present and future retirees should prepare for muted U.S. stock and bond returns relative to historical experience.
- High valuations suggest that retirement withdrawal rates that were once safe may now deliver success rates that are no better – or even worse – than a coin flip.
- This outlook is by no means a call for despair, but rather highlights the increasing need for taking control of one’s destiny by controlling both investment and non-investment factors that can improve the odds of successfully meeting one’s retirement goals.

We are always on the lookout for interesting data visualizations related to the financial markets. Recently, two such charts have come across our computer screens.

# The Drumbeat of High Equity Valuations Grows Louder

The first chart is from a recent article from Goldman Sachs Asset Management (“GSAM”)[1]. It reinforces the importance of developing realistic forward-looking expectations for asset class returns. This is a topic that we have droned on and on about over the last couple of years and one that we feel is especially important today, when the valuation backdrop for many core asset classes are stretched by historical standards.

The clear takeaway, at least in GSAM’s eyes, is found in the blue text in the upper right: “*In 99% of the time at current valuation levels, equity returns have been single digit or negative*.”

Now, there are a few complicating factors with the chart and this conclusion:

- There is some hindsight bias embedded in the chart. In December 1999, when the S&P 500 reached an all-time high Shiller CAPE of 44.2, there was no way of knowing with certainty that valuations weren’t going even higher. After all, for an example of higher than tech bubble valuations, we need look no further than Japan.
- The median rolling 10-year return for the S&P 500 over this period was 8.5%, so be careful in drawing the following conclusion: Equity returns have been “bad” 99% of the time when we’ve been at or near current valuation levels. A better conclusion to draw would be something like: Equity returns have tended to be average to below average when we’ve been at or near current valuation levels. When S&P 500 valuations were between the 75
^{th}and 100^{th}percentile, subsequent 10-year returns were below the median of 8.5% approximately 80% of the time. The odds of a negative 10-year return, even at these valuation levels, is a pretty modest one in eight. - Mean reversion in valuations can take a very, very long time. For those looking to sell high and buy low (or vice-versa), the path to success can be terribly frustrating, requiring Buffett-like discipline to capture the eventual rewards. For example, Shiller’s CAPE rose above the 75
^{th}percentile in January 1992. From this already high point, equities rallied another 300%+ before valuations peaked in late 1999. CAPE would not fall below the January 1992 value of 19.8 until October 2008. - There is a strong argument that valuations are driven by behavioral factors. For example, Jeremy Grantham discussed such a behavioral model in GMO’s most recent quarterly letter. He argues that the two factors most important in explaining high valuations are high profit margins and low inflation volatility. Viewed in this way, mean reversion would require one or both of these conditions to reverse course.

# Visualizing Retirement Success and Failure

The second visualization comes from a recent post on Reddit; a news aggregation, web content rating, and discussion website; by a user going by the name zaladin. The graph shows the retirement wealth paths for various combinations of withdrawal rates and stock/bond splits.

However, before we start we want to point out that this is a highly simplified example. We only consider U.S. stocks and bonds, we don’t consider taxes or fees, etc.

In reality, the following factors can play a significant role in developing a retirement strategy: Alpha (investment performance vs. broadly diversified market portfolios), fees, taxes, desire to leave an inheritance to heirs, longevity/time horizon, diversification/risk management, spending flexibility, risk tolerance, valuation environment, etc.

Returning to our simplistic world, we’ve recreated the graph for a 4% inflation-adjusted withdrawal rate and a 60/40 stock/bond split below. In order to present data going back more than a century, we stick to U.S. equities for our stock exposure and 10-Year U.S. Treasuries for our bond exposure.

The horizontal (x-axis) represents the year when retirement starts. The vertical (y-axis) represents a given year in history. The coloring of each cell represents the savings balance at a given point in time. The meaning of each color as follows:

**Green****:**Current account value greater than or equal to initial account value (e.g. an investor starting retirement with $1,000,000 has a current account balance that is at least $1,000,000).**Yellow****:**Current account value is between 75% and 100% of initial account value**Orange****:**Current account value is between 50% and 75% of the initial account value.**Red****:**Current account value is between 25% and 50% of the initial account value.**Dark Red****:**Current account value is between 0% and 25% of initial account value.**Black**: Current account value is zero; the investor has run out of money.

The diagonal gray lines represent 20, 30, 40, and 50 years, respectively, after retirement.

*Historical Wealth Paths for a 4% Withdrawal Rate and 60/40 Stock/Bond Allocation*

One downside of the above visualization is that it only considers one withdrawal rate / portfolio composition combination. If we want the see results for withdrawal rates ranging from 1% to 10% in 1% increments and portfolio combinations ranging from 0/100 stocks/bonds to 100/0 stocks/bonds in 20% increments, we would need sixty graphs!

To distill things a bit more, we will look at the historical “success” of various investment and withdrawal strategies. We will evaluate success on three metrics:

- Absolute Success Rate (“ASR”): The historical probability that an individual or couple will not run out of money before their retirement horizon ends.
- Comfortable Success Rate (“CSR”): The historical probability that an individual or couple will have at least the same amount of money, in real terms, at the end of their retirement horizon compared to what they started with.
- Ulcer Index (“UI”): The average pain of the wealth path over the retirement horizon where pain is measured as the severity and duration of wealth drawdowns
*relative to starting wealth*. [Note: Normally, the Ulcer Index would be measured using true drawdown from peak, however, we believe that using starting wealth as the reference point may lead to a more accurate gauge of pain.]

We will evaluate these three metrics over a 30-year retirement horizon. Please feel free to reach out if you’d like to see the analysis for different horizon length.

*Absolute Success Rate for Various Combinations of Withdrawal Rate and Portfolio Composition – 30 Yr. Horizon*

We see that withdrawal rates of 3% or less succeeded 95%+ of the time based on “ASR” regardless of asset allocation. A 4% withdrawal likewise succeeded with 90%+ historical probability as long as some equity exposure was incorporated into the portfolio. No stock/bond mix was able to support a withdrawal rate of 5% or more while succeeding at least nine times out of ten.

*Comfortable Success Rate for Various Combinations of Withdrawal Rate and Portfolio Composition – 30 Yr. Horizon*

The results with “CSR” as our success measure largely mirror the “ASR” results. The only main differences are:

- A 100% bond portfolio with a 3% withdrawal rate only leaves the investor with 100% of more of their initial wealth at the end of retirement in about two-thirds of scenarios. For an investor to achieve 90%+ CSR success with a 3% withdrawal rate, some equity is required.
- Succeeding 90%+ of the time with a 4% withdrawal rate requires holding more stocks than bonds.

*Ulcer Index for Various Combinations of Withdrawal Rate and Portfolio Composition – 30 Yr. Horizon*

The Ulcer Index is a measure that summarizes the severity and duration of wealth drawdowns. We like this metric as it provides us some idea of how emotionally stressful a given market path is for investors. In our view, high investing stress not only is unenjoyable, but also raises the likelihood of making poor, emotionally-charged decisions.

Interpreting an individual Ulcer index alone can be difficult, but the relative values provide context. For example, for a 4% withdrawal rate, even though the portfolios with some equity had 90%+ ASRs, the 60/40 portfolio had the least stress, on average – even less than the slightly more successful (from a CSR standpoint) 80/20 portfolio.

**So, what do these equity valuation and retirement visualizations have to do with one another?**

For many investors, market returns are only the means to an end. Ultimately, investors are looking to achieve their financial goals. We certainly know that muted long-term returns in core stocks and bonds are not a good thing. But it can be hard to immediately understand what the true impact of such an outcome would be.

To see the effect of muted returns more clearly, we are going to recreate the retirement visualizations from earlier, but with one key modification: we adjust historical stock and bond returns downward so that the long-term averages are in line with realistic future return expectations given current valuation levels. We do this by subtracting the difference between the actual average log return and the forward-looking log return from each year’s return. By doing this, we reflect subdued average returns while retaining the peaks and valleys that we would expect in actual rolling 30-year periods.

Specifically, we use the “Yield & Growth” capital market assumptions from Research Affiliates. These capital market assumptions assume that there is no valuation mean reversion (i.e. valuations stay the same going forward). The adjusted average nominal returns for U.S. equities and 10-year U.S. Treasuries are 5.3% and 3.1%, respectively, compared to the historical values of 9.0% and 5.3%.

*Historical Wealth Paths for a 4% Withdrawal Rate and 60/40 Stock/Bond Allocation with Current Return Expectations*

With updated return assumptions, we see a dramatically different picture with a lot less green and a lot more of the dreaded black (i.e. fully exhausting one’s savings). The results are similar across withdrawal rates and asset allocations.

We see that only withdrawal rates of 2% or less would have achieved 90%+ success over thirty years regardless of asset allocation. High success rates can still be attained with a 3% withdrawal rate assuming investors are willing to bear the risk of moderate to aggressive equity allocations. Unfortunately, a 4% withdrawal rate no longer offers the safety that actual experience has suggested.

*Absolute Success Rate for Various Combinations of Withdrawal Rate and Portfolio Composition with Average Stock and Bond Returns Equal to Current Expectations – 30 Yr. Horizon*

In our example, passing on starting wealth to heirs at the end of retirement looks difficult except at withdrawal rates of less than 3%. The same can be said for investors looking for a stress-free journey as Ulcer Index values are much higher in this scenario for 3%+ withdrawal rates than what we saw using historical returns.

*Comfortable Success Rate for Various Combinations of Withdrawal Rate and Portfolio Composition with Average Stock and Bond Returns Equal to Current Expectations – 30 Yr. Horizon*

*Ulcer Index for Various Combinations of Withdrawal Rate and Portfolio Composition with Average Stock and Bond Returns Equal to Current Expectations – 30 Yr. Horizon*

**Conclusion: Taking Control of Retirement**

High valuations of core assets in the U.S. suggest that retirement withdrawal rates that were once safe may now deliver success rates that are no better – or even worse – than a coin flip. Unfortunately, we cannot control the returns of U.S. stocks or bonds (or any asset class returns for that matter).

But we can take control of the factors that we can influence.

For a current or future retiree, this means controlling to the extent possible factors like taxes, saving, and spending. From an investment perspective, it means:

- Being strategic, not static: Have a thoughtful, forward-looking outlook when developing a strategic asset allocation. This means having a willingness to diversify U.S. stocks and bonds with the ever-expanding palette of complementary asset classes and strategies.
- Directly address the role of behavioral finance by recognizing that an investor must have the willingness to stick with a plan in order to succeed (e.g. the journey is just as important as the destination).
- Utilize a hybrid active/passive approach for core exposures given the increasing availability of evidence-based, factor-driven investment strategies.
- Be fee-conscious, not fee-centric. For many exposures (e.g. passive and long-only core stock and bond exposure), minimizing cost is certainly appropriate. However, do not let cost considerations preclude the consideration of strategies or asset classes that can bring unique return generating or risk mitigating characteristics to the portfolio.
- Look beyond fixed income for risk management given low interest rates.
- Recognize that the whole can be more than the sum of its parts by embracing not only asset class diversification, but also strategy/process diversification.

These are all ideas that help form the foundation for our QuBe Model Portfolios.

Retirement success and muted future returns are not mutually exclusive. However, achieving financial goals in such an environment requires careful planning for factors that may have been safely ignored given the generous market tailwinds of prior decades.

[1] Goldman Sachs Asset Management, “The Synchronized Expansion.” https://www.gsam.com/content/gsam/us/en/advisors/market-insights/market-strategy/market-know-how/2017/Q32017.html#section-background_ebd2_background_moduletitle_874b

## Addressing Low Return Forecasts in Retirement with Tactical Allocation

By Nathan Faber

On September 25, 2017

In Risk Management, Sequence Risk, Weekly Commentary

This post is available for download as a PDF here.SummaryOver the past few weeks, we have written a number of posts on retirement withdrawal planning.

The first was about the potential impact that high core asset valuations – and the associated muted forward return expectations – may have on retirement.

The second was about the surprisingly large impact that small changes in assumptions can have on retirement success, akin to the Butterfly Effect in chaos theory. Retirement portfolios can be very sensitive to assumed long-term average returns and assumptions about how a retiree’s spending will evolve over time.

In the first post, we presented a visualization like the following:

Historical Wealth Paths for a 4% Withdrawal Rate and 60/40 Stock/Bond AllocationSource: Shiller Data Library. Calculations by Newfound Research. Analysis uses real returns and assumes the reinvestment of dividends. Returns are hypothetical index returns and are gross of all fees and expenses. Results may differ slightly from similar studies due to the data sources and calculation methodologies used for stock and bond returns.The horizontal (x-axis) represents the year when retirement starts. The vertical (y-axis) represents the years post-retirement. The coloring of each cell represents the savings balance at a given point in time. The meaning of each color as follows:

Green:Current account value greater than or equal to initial account value (e.g. an investor starting retirement with $1,000,000 has a current account balance that is at least $1,000,000).Yellow:Current account value is between 75% and 100% of initial account valueOrange:Current account value is between 50% and 75% of the initial account value.Red:Current account value is between 25% and 50% of the initial account value.Dark Red:Current account value is between 0% and 25% of initial account value.Black: Current account value is zero; the investor has run out of money.We then recreated the visualization, but with one key modification: we adjusted the historical stock and bond returns downward so that the long-term averages are in line with realistic future return expectations[1] given current valuation levels. We did this by subtracting the difference between the actual average log return and the forward-looking long return from each year’s return. With this technique, we capture the effect of subdued average returns while retaining realistic behavior for shorter-term returns.

Historical Wealth Paths for a 4% Withdrawal Rate and 60/40 Stock/Bond Allocation with Current Return ExpectationsSource: Shiller Data Library. Calculations by Newfound Research. Analysis uses real returns and assumes the reinvestment of dividends. Returns are hypothetical index returns and are gross of all fees and expenses. Results may differ slightly from similar studies due to the data sources and calculation methodologies used for stock and bond returns.One downside of the above visualizations is that they only consider one withdrawal rate / portfolio composition combination. If we want the see results for withdrawal rates ranging from 1% to 10% in 1% increments and portfolio combinations ranging from 0/100 stocks/bonds to 100/0 stocks/bonds in 20% increments, we would need sixty graphs!

To distill things a bit more, we looked at the historical “success” of various investment and withdrawal strategies. We evaluated success on three metrics:

relative to starting wealth. [2]As a quick refresher, below we present the ASR for various withdrawal rate / risk profile combinations over a 30-year retirement horizon first using historical returns and then using historical returns adjusted to reflect current valuation levels. The CSR and Ulcer Index table illustrated similar effects.

Absolute Success Rate for Various Combinations of Withdrawal Rate and Portfolio Composition – 30 Yr. HorizonAbsolute Success Rate for Various Combinations of Withdrawal Rate and Portfolio Composition with Average Stock and Bond Returns Equal to Current Expectations – 30 Yr. HorizonSource: Shiller Data Library. Calculations by Newfound Research. Analysis uses real returns and assumes the reinvestment of dividends. Returns are hypothetical index returns and are gross of all fees and expenses. Results may differ slightly from similar studies due to the data sources and calculation methodologies used for stock and bond returns.Overall, our analysis suggested that retirement withdrawal rates that were once safe may now deliver success rates that are no better – or even worse – than a coin flip.

The combined conclusion of these two posts is that the near future looks pretty grim for retirees and that an assumption that is slightly off can make the outcome even worse.

Now, we are going to explore a topic that can both mitigate low growth expectations and adapt a retirement portfolio to reduce the risk of a bad planning assumption. But first, some history.

How the 4% Rule StartedIn 1994, Larry Bierwirth proposed the 4% rule, and William Bengen expanded on the research in the same year.[3], [4]

In the original research, the 4% rule was derived assuming that the investor held a 50/50 stock/bond portfolio, rebalanced annually, withdrew a certain percentage of the initial balance, and increased withdrawals in line with inflation. 4% is the highest percentage that could be withdrawn without ever running out of money over an historical 30-year retirement horizon.

Graphically, the 4% rule is the minimum value shown below.

Maximum Inflation Indexed Withdrawal to Deplete a 60/40 Portfolio Over a 30 Yr. HorizonSince its publication, the rule has become common knowledge to nearly all people in the field of finance and many people outside it. While it is a good rule-of-thumb and starting point for retirement analysis, we have two major issues with its broad application:

For example, if we adjust the stock and bond historical returns using the estimates from Research Affiliates (discussed previously) and replicate the analysis Bengen-style, the safe withdrawal rate is a paltry 2.6%.

Maximum Inflation Indexed Withdrawal to Deplete a 60/40 Portfolio Over a 30 Yr. Horizon using Current Return EstimatesSource: Shiller Data Library and Research Affiliates. Calculations by Newfound Research. Analysis uses real returns and assumes the reinvestment of dividends. Returns are hypothetical index returns and are gross of all fees and expenses. Results may differ slightly from similar studies due to the data sources and calculation methodologies used for stock and bond returns.While this paints a grim picture for retirement planning, it’s not likely how one would plan their financial future. If you were to base your retirement planning solely on this figure, you would have to save 54% more for retirement to generate the same amount of annual income as with the 4% rule, holding everything else constant.

In reality, even with the low estimates of forward returns, many of the scenarios had safe withdrawal rates closer to 4%. By putting a multi-faceted plan in place to reduce the risk of the “bad” scenarios, investors can hope for the best while still planning for the worst.

One aspect of a retirement plan can be a time-varying asset allocation scheme.

Temporal Risk in RetirementConventional wisdom says that equity risk should be reduced as one progresses through retirement. This is what is employed in many “through”-type target date funds that adjust equity exposure beyond the retirement age.

If we heed the “own your age in bonds” rule, then a retiree would decrease their equity exposure from 35% at age 65 to 5% at the end of a 30-year plan horizon.

Unfortunately, this thinking is flawed.

When a newly-minted retiree begins retirement, their success is highly dependent on their first few years of returns because that is when their account values are the largest. As they make withdrawals and are reducing their account values, the impact of a large drawdown in dollar terms is not nearly as large. This is known as

sequence risk.As a simple example, consider three portfolio paths:

These returns work about to the expected returns on a 60/40 portfolio using Research Affiliates’ Yield & Growth expectations, and the drawdown is approximately in line with the drawdown on a 60/40 portfolio over the past decade. We will assume 4% annual withdrawals and 2% annual inflation with the withdrawals indexed to inflation.

3 Portfolios with Identical Annualized Returns that Occur in Different OrdersPortfolio C fares the best, ending the 30-year period with 12% more wealth than it began with. Portfolio B makes it through, not as comfortably as Portfolio C but still with 61% of its starting wealth. Portfolio A, however, starts off stressful for the retiree and runs out of money in year 27.

Sequence risk is a big issue that retirement portfolios face, so how does one combat it with dynamic allocations?

The Rising Glide Path in RetirementKitces and Pfau (2012) proposed the rising glide path in retirement as a method to reduce sequence risk.[5] They argued that since retirement portfolios are most exposed to market risk at the beginning of the retirement period, they should start with the lowest equity risk and ramp up as retirement progresses.

Based on Monte Carlo simulations using both capital market assumptions in line with historical values and reduced return assumptions for the current environment, the paper showed that investors can maximize their success rate and minimize their shortfall in bad (5

^{th}percentile) scenarios by starting with equity allocations of between 20% and 40% and increasing to 60% to 80% equity allocations through retirement.We can replicate their analysis using the

reducedhistorical return data, using the same metrics from before (ASR, CSR, and the Ulcer Index) to measure success, comfort, and stress, respectively.Absolute Success Rate for Various Equity Glide Paths with Average Stock and Bond Returns Equal to Current Expectations – 30 Yr. Horizon with a 4% Initial Withdrawal RateComfortable Success Rate for Various Equity Glide Paths with Average Stock and Bond Returns Equal to Current Expectations – 30 Yr. Horizon with a 4% Initial Withdrawal RateUlcer Index for Various Equity Glide Paths with Average Stock and Bond Returns Equal to Current Expectations – 30 Yr. Horizon with a 4% Initial Withdrawal RateSource: Shiller Data Library and Research Affiliates. Calculations by Newfound Research. Analysis uses real returns and assumes the reinvestment of dividends. Returns are hypothetical index returns and are gross of all fees and expenses. Results may differ slightly from similar studies due to the data sources and calculation methodologies used for stock and bond returns.Note that the main diagonal in the chart represents static allocations, above the main diagonal represents the decreasing glide paths, and below the main diagonal represents increasing glide paths.

Since these returns are derived from the historical returns for stocks and bonds (again, accounting for a depressed forward outlook), they capture both the sequence of returns and shifting correlations between stocks and bonds better than Monte Carlo simulation. On the other hand, the sample size is limited, i.e. we only have about 4 non-overlapping 30 year periods.

Nevertheless, these data show that there was not a huge benefit or detriment to using either an increasing or decreasing equity glide path in retirement based on these metrics. If we instead look at minimizing expected shortfall in the bottom 10% of scenarios, similar to Kitces and Pfau, we find that a glide path starting at 40% rising to around 80% performs the best.

However, it will still be tough to rest easy with a plan that has an ASR of around 60 and a CSR of around 30 and an expected shortfall of 10 years of income.

With these unconvincing results, what can investors do to improve their retirement outcomes through prudent asset allocation?

Beyond a Static Glide PathThere is no reason to constrain portfolios to static glide paths. We have said before that the risk of a static allocation varies considerably over time. Simply dictating an equity allocation based on your age does not always make sense regardless of whether that allocation is increasing or decreasing.

If the market has a large drawdown, an investor should want to avoid this regardless of where they are in the retirement journey. Missing drawdowns is always beneficial as long as enough upside is subsequently realized.

In recent papers, Clare et al. (2017 and 2017) showed that trend following can boost safe withdrawal rates in retirement portfolios by managing sequence risk. [6],[7]

The million-dollar question is, “how tactical should we be?”

The following charts show the ASR, CSR, and Ulcer index values for static allocations to stocks, bonds, and a simple tactical strategy that invests in stocks when they are above their 10-month simple moving average (SMA) and in bonds otherwise.

The charts are organized by the minimum and maximum equity exposures along the rows and columns. The charts are symmetric across the main diagonal so that they can be compared to both increasing and decreasing equity glide paths.

The equity allocation is the minimum of the row and column headings, the tactical strategy allocation is the absolute difference between the headings, and the bond allocation is what’s needed to bring the total allocation to 100%.

For example, the 20% and 50% column is a portfolio of 20% equities, 30% tactical strategy, and 50% bonds. It has an ASR of 75, a CSR of 40, and an Ulcer index of 22.

Absolute Success Rate for Various Tactical Allocation Bounds Paths with Average Stock and Bond Returns Equal to Current Expectations – 30 Yr. Horizon with a 4% Initial Withdrawal RateComfortable Success Rate for Various Tactical Allocation Bounds with Average Stock and Bond Returns Equal to Current Expectations – 30 Yr. Horizon with a 4% Initial Withdrawal RateUlcer Index for Various Tactical Allocation Bounds with Average Stock and Bond Returns Equal to Current Expectations – 30 Yr. Horizon with a 4% Initial Withdrawal RateSource: Shiller Data Library and Research Affiliates. Calculations by Newfound Research. Analysis uses real returns and assumes the reinvestment of dividends. Returns are hypothetical index returns and are gross of all fees and expenses. Results may differ slightly from similar studies due to the data sources and calculation methodologies used for stock and bond returns.These charts show that being tactical is extremely beneficial under these muted return expectations and that being highly tactical is even better than being moderately tactical.

So, what’s stopping us from going whole hog with the 100% tactical portfolio?

Well, this is a case where a tactical strategy can reduce the risk of not making it through the 30-year retirement at the risk of greatly increasing the ending wealth. It may sound counterintuitive to say that ending with too much extra money is a risk, but when our goal is to make it through retirement comfortably, taking undue risks come at a cost.

For instance, we know that while the tactical strategy may perform well over a 30-year time horizon, it can go through periods of significant underperformance in the short-term, which can lead to stress and questioning of the investment plan. For example, in 1939 and 1940, the tactical strategy underperformed a 50/50 portfolio by 16% and 11%, respectively.

These times can be trying for investors, especially those who check their portfolios frequently.[8] Even the best-laid plan is not worth much if it cannot be adhered to.

Being tactical enough to manage the risk of having to make a major adjustment in retirement while keeping whipsaw, tracking error, and the cost of surpluses in check is key.

Sizing a Tactical SleeveIf the goal is having the smallest tactical sleeve to boost the ASR and CSR and reduce the Ulcer index to acceptable levels in a low expected return environment, we can turn back to the expected shortfall in the bad (10

^{th }percentile) scenarios to determine how large of a tactical sleeve to should include in the portfolio. The analysis in the previous section showed that being tactical could yield ASRs and CSRs in the 80s and 90s (dark green). This, however, requires a tactical sleeve between 50% and 70%, depending on the static equity allocation.Thankfully, we do not have to put the entire burden on being tactical: we can diversify our approaches. In the previous commentaries mentioned earlier, we covered a number of topics that can improve retirement results in a low expected return environment.

While each modification might only result in a small, incremental improvement in retirement outcomes, the compounding effect can be very beneficial.

The chart below shows the required tactical sleeve size needed to minimize shortfalls/surpluses for a given improvement in the annual returns (0bp through 150bps).

Tactical Allocation Strategy Size Needed to Minimize 10% Expected Shortfall/Surplus with Average Stock and Bond Returns Equal to Current Expectations for a Range of Annualized Return Improvements – 30 Yr. Horizon with a 4% Initial Withdrawal RateFor a return improvement of 125bps per year over the current forecasts for static U.S. equity and bond portfolios, with a static equity allocation of 50%, including a tactical sleeve of 20% would minimize the shortfall/surplus.

This portfolio essentially pivots around a static 60/40 portfolio, and we can compare the two, giving the same 125bps bonus to the returns for the static 60/40 portfolio.

Comparison of a Tactical Allocation Enhanced Portfolio with a Static 60/40 Portfolio with Average Stock and Bond Returns Equal to Current Expectations + 125bps per year – 30 Yr. Horizon with a 4% Initial Withdrawal RateIn addition to the much more favorable statistics, the tactically enhanced portfolio only has a downside tracking error of 1.1% to the static 60/40 portfolio.

Conclusion: Being Dynamic in RetirementFrom this historical analysis, high valuations of core assets in the U.S. suggest a grim outlook for the 4% rule. Predetermined dynamic allocation paths through retirement can help somewhat, but merely specifying an equity allocation based on one’s age loses sight of the changing risk a given market environment.

The sequence of market returns can have a large impact on retirement portfolios. If a drawdown happens early in retirement, subsequent returns may not be enough to provide the tailwind that they have in the past.

Investors who are able to be fee/expense/tax-conscious and adhere to prudent diversification may be able to incrementally improve their retirement outlook to the point where a modest allocation to a sleeve of tactical investment strategies can get their portfolio back to a comfortable success rate.

Striking a balance between shortfall/surplus risk and the expected experience during the retirement period along with a thorough assessment of risk tolerance in terms of maximum and minimum equity exposure can help dictate how flexible a portfolio should be.

In our QuBe Model Portfolios, we pair allocations to tactically managed solutions with systematic, factor based strategies to implement these ideas.

While long-term capital market assumptions are a valuable input in an investment process, adapting to shorter-term market movements to reduce sequence risk may be a crucial way to combat market environments where the low return expectations come to fruition.

[1] Specifically, we use the “Yield & Growth” capital market assumptions from Research Affiliates. These capital market assumptions assume that there is no valuation mean reversion (i.e. valuations stay the same going forward). The adjusted average nominal returns for U.S. equities and 10-year U.S. Treasuries are 5.3% and 3.1%, respectively, compared to the historical values of 9.0% and 5.3%.

[2] Normally, the Ulcer Index would be measured using true drawdown from peak, however, we believe that using starting wealth as the reference point may lead to a more accurate gauge of pain.

[3] Bierwirth, Larry. 1994. Investing for Retirement: Using the Past to Model the Future. Journal of Financial Planning, Vol. 7, no. 1 (January): 14-24.

[4] Bengen, William P. 1994. “Determining Withdrawal Rates Using Historical Data.” Journal of Financial Planning, vol. 7, no. 4 (October): 171-180.

[5] Pfau, Wade D. and Kitces, Michael E., Reducing Retirement Risk with a Rising Equity Glide-Path (September 12, 2013). Available at SSRN: https://ssrn.com/abstract=2324930

[6] Clare, A. and Seaton, J. and Smith, P. N. and Thomas, S. (2017). Can Sustainable Withdrawal Rates Be Enhanced by Trend Following? Available at SSRN: https://ssrn.com/abstract=3019089

[7] Clare, A. and Seaton, J. and Smith, P. N. and Thomas, S. (2017) Reducing Sequence Risk Using Trend Following and the CAPE Ratio. Financial Analysts Journal, Forthcoming. Available at SSRN: https://ssrn.com/abstract=2764933

[8] https://blog.thinknewfound.com/2017/03/visualizing-anxiety-active-strategies/