(James Saft is a Reuters columnist. The opinions expressed are his own)
By James Saft
July 2 (Reuters) - The equity weighting glide path - the idea that savers should cut risky holdings of stocks mechanically as they approach retirement - is an appealing metaphor, easy to understand and instinctively right feeling.
But for many, especially those unlucky enough to live through one of the many historical extended periods of low returns, that glide path ends well short of the runway.
One of the fundamental early insights of investing has been that, as equities are volatile, as you approach needing your savings to live on you should cut back on stocks and buy bonds.
That underlies the old wealth advisor's rule of thumb: that one should have an equity weighting of 110 minus current age, giving a 55-year old, for example, a 55 percent exposure to stocks but a 25-year-old an 85 percent weighting.
Most target-date funds, which have become hugely popular among savers in defined contribution plans, also follow similar paths, ratcheting down equity exposure on a glide path to retirement.
That works well if returns are typical, but they too seldom are.
Ben Inker and Martin Tarlie of asset manager GMO, who looked at this approach and ran the numbers on how it would perform using data going back to 1881, found some disturbing outcomes.
Using a typical target-date fund allocation formula as a hypothetical, and assuming a 55-year-old saver who at that juncture was on target for generating the wealth needed for retirement, Inker and Tarlie found the poor soul running out of money before age 95 more than half the time. (https://www.gmo.com/America/CMSAttachmentDownload.aspx?target=JUBRxi51II...)
While that is counterbalanced by the near equal number who still have money, some a very tidy pile, it is a shockingly bad result in a time in which an increasing number of people are living to an extended age.
"We believe that the right way to build portfolios for retirement is to focus on how much wealth is needed and when it is needed, with a focus not on maximizing expected wealth, but on minimizing the expected shortfall of wealth from what is needed in retirement," Inker and Tarlie write.
The real problem with target-date funds, indeed with much investment thinking, is that it assumes that expected returns will be constant over time, something that really can only be taken for granted by those of us who will live forever.
For the rest of us, we have to deal not just with volatility on a day-to-day and quarter-to-quarter basis, but with the very real risk that we just happen to be saving at a bad time. Just looking at U.S. data also probably gives an unrealistically rosy picture of how often this happens. Just think, to name but one example, of all the Germans whose retirement equity savings would have been wiped out by World War I.
One useful tool in managing risk, of variation in returns if not of war, is using valuations as an input to help determine how much to commit to stocks. There has been a strong historical correlation, Inker and Tarlie point out, between stock market valuations and subsequent returns.
In other words, if you hold less equities at times of high valuation and more when stocks are cheap you can improve your returns even while still broadly following a glide path towards retirement.
For example, if the market was on a Shiller P/E of 19 (vs a typical 16), a 65-year-old might hold just 20 percent in stocks, about half the typical target date fund allocation.
Running the numbers on this dynamic allocation approach, Inker and Tarlie find that the probability of our 55-year-old of going bust before 95 drops to 13 percent, as against 52 percent for the target date example. Not perfect, but a heck of a lot better.
To be sure, returns revert to mean but often not on schedule. That said, the longer you can wait the higher the chances are that your over- and under-weighting based on valuation pays off.
One other tool which seldom gets discussed in managing these risks is the simplest: the savings rate. Savers who are running behind their wealth accumulation targets for whatever reason really should be upping their contributions.
While not an easy sell to a client ("Invest with us and consume less!") this reduces the risk of a shortfall in retirement without compelling the saver to make judgments about the likely future path of markets.
With more than $650 billion invested in target-date funds, according to Morningstar data, the stakes for a nation increasingly populated by future 95-year-olds are high. (At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at firstname.lastname@example.org and find more columns at http://blogs.reuters.com/james-saft) (Editing by James Dalgleish)