The Best Asset Allocation For Retirees

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The Best Asset Allocation for Retirees; Initial Conditions and the Optimal Retirement Glide Path Shape

April 21, 2015

by David Blanchett

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There has been growing interest recently in the optimal glide path shape for retirees. Previous research by Pfau and Kitces (2014) noted that rising glide paths were optimal.  My own recent research (2015), which incorporated today’s low bond yields, noted declining glide paths were best. Even more recent research by Kitces and Pfau (2015), which incorporated market valuations (using the Shiller P/E metric), again confirmed that increasing glide paths are best.

All these smart people are reaching different conclusions. What gives?

It turns out that the optimal glide path depends significantly on the return assumptions, especially early in retirement. Using a model based entirely on long-term averages yields results that are very different than a model based on available returns today.

In this article, I determine the optimal glide path shape for retirees using varying initial bond yields and stock market valuations. Increasing glide paths perform best in moderate- and higher-return environments, while decreasing glide paths perform better in lower-return environments (especially when bond yields are low).

With retirees facing both low bond yields and a high market valuation, decreasing glide paths are slightly more optimal; however, the results do not vary that significantly across the glide paths (decreasing, increasing or constant).

Market conditions today

Retirees have to consider both the bond yields and stock market conditions at the onset of retirement. I use two key indicators to forecast the future returns for bonds and stocks: 10-year U.S. government bond yields and the Shiller CAPE ratio. Bond yields reliably predict the future returns of bonds because a majority of the return is the coupon, which is known at the time of purchase.

The CAPE ratio was introduced by Campbell and Shiller (1998) and is calculated by dividing the price of the S&P 500 by the average real earnings over the previous 10 years. Those researchers noted that this metric can explain about 30% of subsequent real stock returns over a 10-year horizon. Research by Davis, Aliaga-Díaz and Thomas (2012) also noted the historical predictive benefit of the CAPE ratio versus other common forecasting metrics. The historical relation between each of these metrics is included in Figure 1 for bonds and stocks, in Panels A and B, respectively.

Figure 1: Future Returns Based on Initial Conditions

Panel A: Bond Yields and Future Bond Returns   Panel B: The CAPE Ratio and Future Stock Returns

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