There was a time when video games didn't allow players to save their progress. Zelda, I believe, was the first Nintendo game to include a battery in the cartridge that enabled players to go save a game and restart from that point. As an 8-year-old playing Contra, we used cheat codes to get 30 lives in order to try and beat the game. There are no cheat codes to go back and restart after a bear market, but we can save our progress. If the decade-long bull market means you're further along in saving for retirement than you expected to be, now might be a good time to do so.
In order to avoid the worst-case outcomes inherent in all-equity portfolios, we need to first identify how they occur. There are two main causes: (1) low returns and (2) sequence of returns risk. I've selected two trials from my simulation to illustrate both of these causes.
Click here to view a chart of the two hypothetical accumulation trials.
Trial 61 is a low-return trial. At no point did the accumulated assets surpass 8.5x final year's earnings. In many ways, a 35-year period of low returns is simply bad luck. It's possible that it will occur, but there's only so much an investor can do to mitigate such an outcome. One option is to hold fixed income and other asset classes, but the obvious trade-off is worse outcomes most of the time. Without perfect foresight, it's hard to confidently predict a multi-decade period where equities underperform most other asset classes.
Trial 465 is a sequence of returns risk trial. In this trial, the investor had accumulated the equivalent of 16.4x final year's earnings, only to see the portfolio decline by nearly half due to a bear market right before retirement.
Unlike the investor in trial 61, the investor in trial 465 can potentially improve her outcomes recognizing that she's close to meeting her objectives and "saving her progress" by de-risking her portfolio ahead of retirement. This way of thinking about portfolio selection, where the future goals and objectives for a pool of assets have a big impact on how those assets are invested, is what pensions call liability-driven or liability-responsive investing. It's also a big part of our Liquidity. Longevity. Legacy. (3L) framework.
In simple terms, using liability-responsive asset allocation in this situation might mean starting with an all equity portfolio, but reducing the equity portion by 20% when the investor has 70% of her target retirement funds, reducing by another 20% when she's reached 80% of her target funds, and so on.
I reran the same analysis as in my last post, but included a liability-responsive strategy that reduces risk as the investor gets closer to fully-funding her retirement portfolio. The result: better outcomes across the board, except in the top 25% of outcomes. That's the trade-off. An investor taking this approach potentially misses a really big final year in the market in exchange for also avoiding the other side of the same coin: a bear market right before retirement.
Main contributor: Michael Crook, Head Americas Investment Strategy
Liquidity. Longevity. Legacy. disclaimer. Timeframes may vary. Strategies are subject to individual client goals, objectives, and suitability. This approach is not a promise or guarantee that wealth, or any financial results, can or will be achieved.
Save your progress. There are no cheat codes for retirement. 22 April, 2019.