Research suggests that the riskiest time for an investor are the years surrounding their retirement date when sequence of return risk is greatest. If an investor were to receive very favorable returns during the initial years of their retirement, the odds of running out of money in retirement as they spend down their assets is reduced. For the unlucky investor who receives a poor sequence of returns, the odds of running out of money greatly increase. There are two common potential solutions for managing this sequence of return risk, however a deeper understanding of the nature of risk, combined with an understanding of alternative investment allocations and strategies, might be the crucial missing link investors should consider to improve their chances of success in retirement.
An “equity glidepath” refers to an investment strategy that involves adjusting the allocation of assets, particularly the proportion of a portfolio invested in stocks, over a predefined time horizon. The primary goal of an equity glidepath is to manage the sequence of return risk characteristics of a portfolio as an investor progresses through different life stages or time horizons.
Typically, the equity glidepath starts with a higher allocation to equities in the early years and gradually reduces the exposure to stocks as the investor approaches retirement or a specific financial goal. This gradual reduction in equity exposure is designed to protect the portfolio from the heightened volatility associated with stocks, especially during the later stages of an investor's life. The concept is rooted in the idea that younger investors can afford to take on more risk by holding a higher percentage of equities, given their longer time horizon and ability to recover from market downturns.
An equity glidepath is often implemented through target-date funds, which automatically rebalance the asset allocation based on the investor's expected retirement date. The overall concept of rebalancing our asset allocations from risky to conservative using traditional stock and bond allocations can also be accomplished with a similar, but potentially more effective strategy…a “bond tent.”
A “bond tent” is an investment strategy that involves adjusting the allocation of one's investment portfolio over time, particularly in the years leading up to and during retirement. Initially similar to an equity glide path strategy, a bond tent strategy involves reallocating from an equity heavy portfolio to a bond heavy portfolio as an investor approaches retirement. However, in a bond tent strategy the retiree will then reallocate back into equities as they move further into retirement. If we were to graph this out visually, the allocation to bonds resembles a “tent,” with increasing bond exposure up until retirement and then decreasing exposure as retirement years pass.
The primary problem with an equity glidepath strategy is that although beneficial for managing sequence of return risk in the initial stages of retirement, it maintains an overly conservative posture, increasing inflation risk for the retiree. Once again, being overly conservative is paradoxically risky! The bond tent strategy allows the investor to navigate sequence of return risk when it is greatest, and then adjust for inflation risk by reallocating to equities as time progresses.
Notice the problem here? If investors are primarily utilizing target date funds to save, they run the risk of staying overly conservative after exiting the riskiest part of their initial retirement. As of today, most target date funds are one-way tickets to an extremely heavy bond allocation. An investor will have to make the active decision to rebalance into a progressively more volatile portfolio as time passes in retirement. Mathematically it is the correct thing to do but think of the psychological hurdle a retiree must jump over to accept increasing portfolio volatility in retirement!
And Then Your Bonds Get Thrown Out the Window
It is September of 2020. You are getting ready to retire and still in the midst of dealing with a pandemic, lockdowns, social distancing, the loss of loved ones. Your target date retirement fund in your 401(k) is heavily invested in bonds, and the Federal Reserve has done an outstanding job of demolishing interest rates to practically zero. With nowhere else to go but up, interest rates start to climb with inflation, and being that interest rates are the inverse of bonds, your portfolio is positioned in the worst way possible for one of the worst bond drawdowns in United States history.
Whether utilizing an equity glide path or bond tent strategy, you are now experiencing a poor sequence of returns even after utilizing traditional methods of avoiding sequence of return risk! Unlucky? Most definitely! Avoidable? Potentially…
Stay tuned as we will explore a number of alternatives in Part 2 of “Building a Better Bond Tent…Beyond Bonds”
This material contains the current opinions of the author but not necessarily those of Park Avenue Securities, Guardian or its subsidiaries and such opinions are subject to change without notice. It is provided for informational and educational purposes only and not to recommend a particular course of action. Statements of financial market trends are based on current market conditions and are subject to change without notice. References to specific securities, asset classes and financial markets are for illustrative purposes only and do not constitute a solicitation, offer, or recommendation to purchase or sell a security.
All investments contain risk and may lose value.
Investing in the bond market is subject to certain risks including market, interest rate, issuer, credit and inflation risk.
Equities may decline in value due to both real and perceived general market, economic and industry conditions.
2023-165462 Exp 11/25