For decades, most financial advisors have clung to a central belief about asset allocation: The older you are, the more fixed income you should hold. Retirees should gradually shift away from equities, and into bonds, the thinking goes. That way the investor's nest egg will be protected if stocks collapse.

Now, two academics have challenged this core bulwark of financial planning. In a study published in the October issue of the Journal of Financial Planning, the iconoclastic professors argue that retirees should spend their bonds first, gradually lowering the fixed-income allocation. “The greater the exposure to equities, the less likely that a retiree will exhaust his savings,” says John J. Spitzer, a professor at the State University of New York in Brockport, who co-authored the study with his SUNY colleague Sandeep Singh.

While the academic findings may be controversial, the study is particularly noteworthy because it comes at a time when more companies are introducing retirement-date funds. Offering one-stop shopping, these retirement funds automatically increase their allocations to fixed income as the investor ages. Consider the Fidelity Freedom funds, one of the most popular target-date fund options. The Fidelity funds have 90 percent of assets in equities when retirement is 43 years away; the equity position drops to 81 percent when retirement is 23 years in the future, and 43 percent when the saver has been retired for two years. Investors have expressed confidence in the orthodox approach of target-date funds. Total assets in these kinds of funds have surged, reaching $114 billion in 2006, up 60 percent from the year before, according to the Investment Company Institute, the mutual fund trade group.

To maintain the target allocations, the funds regularly rebalance, trimming overweight positions, and reinvesting the cash in underweight sectors. But the academics warn that rebalancing is hazardous for retirees. “Rebalancing is not necessary — and it can be harmful,” says Sandeep Singh.

To test the value of rebalancing, the researchers examined 10,000 scenarios. Using data from historical market returns, the professors looked at how different portfolios would have performed during 30-year periods. In one instance, the hypothetical retiree has 30 percent of assets in stocks, and the rest in bonds. He withdraws 4 percent of assets a year. The researchers found that in 22 percent of the simulations, the portfolio would have been exhausted if the investor rebalanced. But if the investor cashed in bonds first, and didn't rebalance, the portfolio would have run out of cash under only 10 percent of the scenarios. In nearly every asset allocation, selling the bonds first resulted in fewer shortfalls.

Tilting At Windmills

While fund companies do not dismiss the study, they show no signs that they will take its findings to heart and alter the asset allocations of their target-date funds. “Theoretically, the professors might be right,” says Dave Liebrock, executive vice president of Fidelity Institutional Services. “But in the real world, things are more complicated.”

The fund executives acknowledge famous Ibbotson data, which show that stocks have outperformed bonds over the long term. On average, an all-stock portfolio would have outperformed an all-bond portfolio during most decades. The problem arises in the messy reality of retirement, where many variables come into play. To appreciate the complexity of saving for retirement, consider someone who retires at 65 with $1 million invested entirely in stocks. During the next five years, the markets drop sharply, and at 70 the retiree has $500,000. Now the retiree could face hard times; if things continue on the current path, he could go broke quite quickly.

Professor Spitzer concedes that his study has only been tested on the theoretical plane. But he argues that rebalancing is not all that it is cracked up to be. Say a retiree starts with a portfolio that is 50 percent in bonds, and 50 percent in equities, Spitzer says. The retiree sells all his bonds over a 12-year period. While the bonds are being liquidated, the stocks are likely appreciating. The odds are very good that the all-stock nest egg would be bigger in year 13 than a rebalanced portfolio that is half in stocks and half in bonds. Spitzer admits that an all-stock portfolio would be volatile. He suggests a partial remedy. If a client feels uncomfortable holding all stocks, then it would be possible to keep at least 20 percent of assets in bonds, he says. The bonds would cushion the portfolio during rough markets. And instead of selling stocks during downturns, the investors could sell some bonds.

Whether financial advisors embrace the academic findings (most would probably think them insane), the study is worth considering because it presents a challenge to the idea of target-date funds. The typical target-date fund comes with a so-called glide path, a plan for lowering the equity allocation. By reading the plan, an investor can know roughly what his asset allocation will be 30 years down the road. This kind of planning is surely better than no planning at all. But the glide paths are crude instruments — not likely to achieve the optimum allocation. What will the best allocation be? That depends on future markets, which are unpredictable. “It is wrong to use a formulaic approach,” says Pran Tiku, president of Peak Financial Management, a registered investment advisor in Waltham, Mass., that clears trades through Charles Schwab. “For retirees, you must constantly monitor the allocation, and make adjustments when they are needed.”

Before retiring, a client must do some soul-searching about withdrawal rates and risk tolerance, says Tiku. Then once the retirement begins, the financial advisor must watch the markets and the client's spending patterns. If stocks soar in the first few years, it may be possible to increase withdrawals. The lucky client may decide to invest more heavily in stocks, hoping to build assets for heirs or charity. “The mix of stocks and bonds needs to evolve over time as the investor realizes actual market returns,” says Tom Idzorek, vice president of research for Ibbotson Associates. “Individuals may need to adjust their standard of living based on what is happening in the market.”

Instead of spending all the bonds first, as the professors suggest, Tiku follows a more flexible approach. He holds enough cash and short-term bonds to cover living expenses for two years. That way he can usually avoid selling stocks or bonds into a downturn. To raise additional cash, he trims either stocks or bonds, selling whichever asset is over-weighted. By rebalancing the stocks and long-term bonds, he holds down risk and helps clients generate steady income.

GOING BROKE?

To determine whether retirees should rebalance their portfolios, SUNY professors John Spitzer and Sandeep Singh looked at how different portfolios would have performed in past markets. In most instances, retirees who rebalanced their nest eggs were more likely to go broke than those who spent all the bonds first.

Stock percentage of portfolio Withdrawal rate % of assets annually % of shortfalls in rebalanced portfolios % of shortfalls in portfolios that sold bonds first
30% 4% 22% 10%
30 5 69 37
60 4 6 4
60 5 35 18
70 4 4 2
70 5 29 16
Source: Journal of Financial Planning