Sequence of Returns and Target Date Funds

[Louisville]

https://www.americancentury.com/content/dam/americancentury/ipro/pdfs/viewpoints/iuo/Importance_of_Sequence_of_Returns_Risk_in_Target_Date_Strategies.pdf

My take away, not just from this article but my own thinking:
You should have your most conservative allocation on the day you start drawing down your nest egg, since that is when you are at highest risk. How conservative that allocation should be is another discussion. You're at highest risk at the outset because a loss of value while you're drawing down hits you harder the earlier it happens.
Most target date retirement funds, however, seem to move to their most conservative allocation 5-20 years after the target retirement date.
Do they know someting I don't? Probably.
What is it?

[arebelspy]

You should have your most conservative allocation on the day you start drawing down your nest egg, since that is when you are at highest risk.

So you're in favor of increasing risk as you get older?

Say, retire with 40/60, and increase the equity exposure as you age so you're 90/10 by death or something?

(Note: There are some good arguments for this, Pfau has an interesting paper on a rising equity glide-path, I'm just trying to clarify if that's what you mean by most conservative on the day you ER - to increase risk over time.)

[Louisville]

Well, I actually just meant hitting the most conservative allocation at retirement time and staying there until death. But, now that you mention it, if there was enough money and I had my wits about me, maybe increasing volatility/risk late in life could be a viable strategy.

[matchewed]

Well, I actually just meant hitting the most conservative allocation at retirement time and staying there until death. But, now that you mention it, if there was enough money and I had my wits about me, maybe increasing volatility/risk late in life could be a viable strategy.

Not only viable but necessary depending on how things hash out in the future. In an environment with low interest rates bond positions may be barely keeping up w/ inflation. It all depends on how things turn out and for you to have thought about these things, how they may turn out, and how you plan to address them.

[Louisville]

Thanks for the replies. Before this thread goes off on talking about whether to increase risk into old age, please ya'll don't forget about my original question about why/why not to have your most conservative allocation at the beginning of draw down time.

[matchewed]

So you want to know why or why not to have your AA at its most conservative right when your retire? It's easy. You want the smallest possible drop at that particular point if it happens to drop. Just look at cFIREsim and run a scenario right before a crash and a scenario at any other time. Right before a crash will almost always have the lowest return. It's the highest risk (outside of inflation itself) to a retirement portfolio.

[Louisville]

So you want to know why or why not to have your AA at its most conservative right when your retire? It's easy. You want the smallest possible drop at that particular point if it happens to drop. Just look at cFIREsim and run a scenario right before a crash and a scenario at any other time. Right before a crash will almost always have the lowest return. It's the highest risk (outside of inflation itself) to a retirement portfolio.

Yeah, so what's the opposing rational? Why do target date funds take their glide path out past the target date?

[arebelspy]

Typically one would decrease their equity exposure as they get older.

Having an already overly conservative asset allocation at the time that you FIRE means you'll have to work longer to support that. Though, to be honest, there's not necessarily that much difference between 40/60 and 60/40, and even stuff right above and below that.

But I think it's just the idea that people want their risk decreasing as they get older, therefore the funds accommodate that.

[matchewed]

Yeah like Rebs said it is more about an emotional crutch or a system of thought around traditional retirement  than a thought based on the math and historical performance. Those managers in the target date funds are just going with traditional advice. That advice is to become more conservative with your AA as you get older. One reason may be that once you've won the game no need to keep playing, so to speak. For instance if someone were to hand me $1mil tomorrow I'd probably put it in a very conservative AA as I wouldn't need that much growth since my number is $500k-ish given the current value of a dollar. But when I hit my number I'm staying relatively aggressive for a large portion of my timeline because I'm relying on the growth of equities to pull it off sooner. The lower my predicted return the longer it will take to hit my number (I use 4% return after inflation personally at this time).

Put another way, wealth preservation is the function of a conservative allocation (typically). Wealth growth is the function of an aggressive portfolio (typically).

[EscapeVelocity2020]

Just anecdotally from browsing the Early-Retirement.org forum (note, E.R. in this case skews toward 55+ y.o. and not 35- y.o.), it seems like in the real world, folks get to 60/40 and their magic retirement number and stay around that exposure.  You don't hear much about retirees using target date funds on that board.

The rub, for me, is that retiring at, say 40, gives you a really long retirement to have to fund so you are exposed to SOR risk longer (i.e. until being eligible for Social Security and Medicare).  The more bonds you have, the more you are guaranteeing you will have less overall growth in your portfolio.  So, on one hand, you want to have your most conservative portfolio at retirement to minimize SOR risk blowing up your all stock nest egg within the first 20 years of a 50 year retirement, but on the other hand, you know bonds have a lower expected total return and, since you have a long retirement to fund, inflation could make your real returns on bonds almost zero or even negative...

I agree with the paper you cite and the folks at ER.org, get to your number with something around a 50/50 portfolio, run it through cFIREsim and voila, depending on success rate you are comfortable with, you're FI.  Don't need to get more aggressive with age, unless you really want to go for broke on a big estate (meh) and don't need to get more conservative with age, 50/50 and annual rebalance is a happy medium between low volatility and necessary growth exposure...
 

[skyrefuge]

A glide path that is "more conservative" in terms of sequence-of-return risk is "more risky" in terms of inflation/outliving-your-assets risk. Different glide paths don't reduce overall risk, they simply shift from one risk to another risk.

Some people, due to their inherent personality, as well as their particular financial situation/age, are better suited to handle one type of risk vs. another type of risk. For example, for a nervous person with a short (20 year) retirement who is likely to sell all his stocks after a 20% drop, a bond-heavy portfolio at retirement is the better choice. On the other hand, for a 35-year-old retiree with a strong ability to stay-the-course during stock market crashes, a stock-heavy portfolio at retirement is a better choice.

Target-date funds are a one-size-fits-all approach. When developing a one-size-fits-all product, there are a variety of approaches than can be used to best suit your customers. You can develop the product in such a way that it fits 60% perfectly, 10% adequately, and 30% terribly. Or you could do it so it fits 10% perfectly, 80% adequately, and 10% terribly. Which one is the "correct" way to do it? There is no single answer to that question (especially since no one can even agree on what a "perfect fit" is), and that's why you see different providers have different glide paths in their target-date funds.

So, for people like us who sit around and think about these things and do self-analysis, you're probably better off just setting your own asset allocation/glide path. Or, if you're lucky enough to find a provider who seems to provide a product that indeed is a "perfect fit" for you, then go with that.

[arebelspy]

A glide path that is "more conservative" in terms of sequence-of-return risk is "more risky" in terms of inflation/outliving-your-assets risk. Different glide paths don't reduce overall risk, they simply shift from one risk to another risk.

Well said.  If you're a lot more conservative with your AA at ER , you're in for more inflation risk for your long ER.

The only way around either of these is to save up way more than you'll likely need (and work longer to do so).