Christine Benz: Hi, I'm Christine Benz for Morningstar.com. The traditional formula for retirement asset allocation calls for ever larger helpings of conservative securities, but some recent research has challenged that assertion. I recently sat down with Vanguard's Steve Utkus to discuss that topic.
Steve, thank you so much for being here.
Steve Utkus: My pleasure.
Benz: I would like to talk about what in-retirement glide paths or asset-allocation frameworks should look like. Let's start with the traditional glide path. There you have equities declining over time. What's the thinking behind that sort of framework?
Utkus: The standard argument is that, as households age, they become more risk-averse and, therefore, have to have declining equity exposure as they age. Now, a sort of standard conventional man-in-the-street argument or woman-in-the-street argument would be "Sure, that intuitively makes sense because maybe the end of work might cause sensitivity to risk or there might be a personal psychological reason." But there is actually a deeper theoretical argument. When you're younger and you're a young worker, if you think of your whole balance sheet, including your financial savings and the net present value of your future lifetime earnings, which we call human capital, you can imagine that at 25 you have this huge stock of human capital and this tiny retirement savings account. And the riskiest part of your portfolio is not what you put in your retirement account, it's your human capital.
And in that light, it's perfectly appropriate to put all of your financial assets in high-risk capital like equities because you have this big thing on your balance sheet called future lifetime earnings. Of course, as you age, the future lifetime earning shrinks, the size of your financial capital increases. And if you want to maintain an overall risk profile, this growing pile of money has to become more conservative.
So, you can have this grand theoretical argument based on the amount of human capital on your balance sheet. I think, also, for many investors, it just seems intuitive that you become psychologically more risk-averse when you don't have that steady income from pay from work.
Benz: So, that is an intuitive framework. It's the one adopted by many retirees. When you look at the income version of target-date funds, that's usually how they work.
Utkus: Yes. Sure.
Benz: But let's talk about some new research that actually turns that on its head and suggests a lower equity allocation for people just starting out retirement that gradually or maybe generally ramps up as the years go by. So, the older retiree gets more and more in equities. Let's discuss the underpinning of that research and also your view of that research. Does that idea make sense to you in practice?
Utkus: Well, not just with respect to older ages but across the entire lifecycle, there has been this debate. Particularly in 401(k) plans and IRAs [US company pension plans and individual savings accounts], as target-date strategies became popular, other commentators began to suggest that those glide paths were sort of lopsided or one-sided. And I think the standard criticism of them is that there are lots of other glide paths you can imagine that will maximize outcomes under a wide range of scenarios.
So, it's not just that there might be some tail risk or some extreme outcome that would keep you from doing this. But in a wide range of outcomes, you'd be better off and wealthier with, say, an increasing equity glide path exposure or a constant equity glide path exposure. And those arguments, while they are sort of useful academically, I think they don't really take into account this risk aversion.
It's interesting. One of the surveys that the ICI does periodically--Investment Company Institute, the trade group for mutual funds--is they actually ask investors about their degree of risk aversion, and you can see it very clearly across ages that risk aversion increases, risk-seeking decreases as people age. So, I think a lot of these models, while they may say that theoretically that the best way to maximize wealth is, for example, to increase equity exposure or to have high degrees of equity exposure as you age, I think the counter argument is really a risk-aversion argument.
Benz: So, it seems that one of the underpinnings of this idea of increasing equities as you age is that you're trying to avoid that sequencing risk, [meaning] getting hit with a really lousy stock market right at the outset of retirement. I think that's one of the goals. That's something that the traditional glide path doesn't address directly, correct?
Utkus: Well, the sequencing risk, it does, because in most modelling scenarios, most glide paths are at 50/50 stocks/bonds or less at retirement age. And so, the sequencing risk that people are worried about is more acute if you have a higher risk. So, I think there is absolutely that argument that there is this short-term sequencing risk that occurs, say, the first five years or perhaps first 10 years of retirement.
The converse of that, of course, is that as you age and need to, say, spend down for other liabilities like long-term care, you don't want to be investing in equities. You want to be investing in short-term cash and fixed-income investments. So, I think that where that sort of falls apart is if you look at the liability stream you're going to have to pay for from your portfolio, that liability can grow quite rapidly, particularly if you need long-term care.
Benz: Well, I want to drill into that a little bit, because I think that's such an important point and something that you don't see a lot about, this idea that your income needs may be very lumpy over your retirement years. And so, you're saying that people need to kind of think about their health and overall wellness when thinking about their asset allocations, especially if they haven't purchased a long-term care insurance policy.
Utkus: That's right. It's intuitive, I think, to most investors that, of course, expenditures in retirement will be lumpy in some sense, whether it's buying a new car or transitioning your housing or even discretionary big expenses like family weddings or vacations. You have some control and degree of variability, year over year, in terms of spending.
So, this idea of a constant real spending in retirement is probably not a really accurate description of what people actually do today. But the interesting thing to me--and I call it the second half of retirement problem--is the question of thinking about the period of frailty, generally post age 80, sometimes post age 85, sometimes post age 75, where you're actually alive and well but need additional support in the form of long-term care--and that includes home nursing care (incidental or around the clock), assisted living, or true long-term nursing care.
And those liabilities sort of come on you suddenly. It's not like you sit down and think, "In five years, I'll the long-term care." It could be the next day; it could be 10 years. And they require suddenly large drawdowns from your portfolio. And I don't think a lot of those in the financial-services industry or a lot of individual investors think enough about that uncertainty. In fact, when I talk to older investors, they see it happening around them, but they say, "Well, that won't happen to me."
So, there is sort of a head-in-the-sand, ostrich [mentality] to saying, "Well, I won't have to deal with that. I'll keep a risky portfolio." Even though the longer you live, the more likely some degree of expenditure will be needed to support a frailer existence. So, I think, as an investment community, as an investment industry, we have to do more thinking about these post-80 expenditures that can loom large and occur unexpectedly.
Benz: Steve, thank you so much. This is such an important topic. We really appreciate you being here to share you insights.
Utkus: It's been my pleasure.
