Putnam: 10% Is Optimal Retirement Equity Allocation

[mickeyd]

I have no idea who or what the Putnam Institute is, but 10% (or even 25%) equity position for a retiree is way too conservative for me. Looks like junk to me unless the retiree is super scared of stocks and is afraid of risk.

Am I missing something?

Research released by the Putnam Institute today produced a conclusion that should shock the financial services industry, including the financial planning profession. The finding that the optimal equity allocation for retirees' portfolio is about 10% is so far out of line with conventional wisdom it left the study's author, Putnam Institute research director Van Harlow, quite surprised.
Depending on various factors, the optimal equity allocation could be as high as 25%, according to the research—still well below widely accepted thinking on retirement investing.

How did Putnam reach this radical conclusion? According to Harlow, the biggest risk retirees face is "sequence of return" risk, or retiring just as a nasty bear market begins.

Putnam: 10% Is Optimal Retirement Equity Allocation

 

[Animorph]

No details available at the link. Not that they could have convinced me they were sane anyway.

 

[haha]

No details available at the link. Not that they could have convinced me they were sane anyway.

Whatever a member here thinks of their credentials, or as in your case, their sanity, the guy who did this study, Dr. Harlow, is no lightweight, and Putnam Investors, his employer, is a very old fund company.
Inaugural Study by Putnam Institute Finds That Optimal Equity Allocation in Retirement Portfolios Should Be Significantly Lower Than Most Current Lifecycle Funds in the Marketplace | Business Wire

Ha

 

[Dawg52]

Wow. And all this time I thought I was a super conservative investor. I need to cut almost half my equity holdings to get to their 10% model.

 

[REWahoo]

Wow. And all this time I thought I was a super conservative investor. I need to cut almost half my equity holdings to get to their 10% model.

I think you can keep [-]drinking[/-] what you've got:

Newly Launched Putnam Investments Think-Tank Determines that Appropriate Range of Equity Allocation in Retirement is Between 5% and 25%

 

[FinanceDude]

Jim Cramer must be knashing his teeth as we speak..........

 

[MasterBlaster]

In a bear market, 10% stock allocation is way too high.

 

[Dawg52]

I think you can keep [-]drinking[/-] what you've got:

Med's baby.

 

[FIRE'd@51]

I suspect that Van Harlow is drawing upon William Sharpe's work on wasted surpluses, although the linked article doesn't make this clear. We have discussed Sharpe's work on this forum before. The basic idea is to put 90% of your retirement portfolio into income-only 30-year TIPS (i.e. TIPS with the maturity payment stripped off). This would provide one with a 30-year inflation-adjusted income stream (at a 4% withdrawal rate) funded by the TIPS interest payments. The remaining 10% would be invested in equities and left untouched for 30 years. After 30 years the TIPS part of the portfolio would be zero (since the maturity payment was stripped off to allow an increased withdrawal rate) and one would have an equity portfolio presumably large enough to "fight-off" longevity risk.

The practical problem with this is that income-only TIPS (although TIPS are eligible for such stripping) don't appear to be readily available (if at all) in the market place. Perhaps, someday our Treasury Dept will issue TIPS securities already stripped this way. If so, this could well be an "optimal" retirement portfolio, IMO.

 

[REattempt]

Study here if you are interested...

PDF of the study output:

https://content.putnam.com/literature/pdf/PI001.pdf

 

[DblDoc]

PDF of the study output:

https://content.putnam.com/literature/pdf/PI001.pdf

The first question that comes to mind is why is it not in a peer reviewed journal?

DD

 

[ziggy29]

In a bear market, 10% stock allocation is way too high.

All you have to do is reliably identify the bear market just before it starts, and just as reliably know when it's just about to end.

 

[ERD50]

Whatever a member here thinks of their credentials, or as in your case, their sanity, the guy who did this study, Dr. Harlow, is no lightweight, and Putnam Investors, his employer, is a very old fund company.
Inaugural Study by Putnam Institute Finds That Optimal Equity Allocation in Retirement Portfolios Should Be Significantly Lower Than Most Current Lifecycle Funds in the Marketplace | Business Wire

Ha

But why is this so at odds with the FIRECALC runs?

I skimmed the pdf, but a few things I noticed were:

1) Assume a 7% WR - maybe this high rate is more sensitive to stock down-drafts (though I just ran a 7% FC run, and it still shows better results with >65% equities.

2) On p3-4, they seem to be making some math assumptions on returns, which is inconsistent with the FC approach of actual historical data...

We also make the base-case assumptions that stock, bonds, and cash have real returns of 6.0%, 3.0%, and 1.0%, and volatilities of 16%, 7%, and 2.5%, respectively.

followed by notes on correlations.

3) On p13 (underline mine) -

These returns, denoted rt, are obtained from historical time series or through Monte Carlo simulation.

Hmmm, so were the failures attributed to the historical, or the Monte Carlo? One wonders.

Could FireCalc really be this wrong after so many eyes have looked it over? I suppose so, but I have my doubts. This study leaves many things open, as far as I can see.


-ERD50

 

[haha]

But why is this so at odds with the FIRECALC runs?

I really was not trying to comment on their findings, or their findings relative to Firecalc, just on the idea that Van Harlow is a hack or lacking in sanity. Neither of these things is true. However this does not mean that the study is necesarily right, or that any plan is necessarily optimal.

Ha

 

[chinaco]

This comment is made in the more narrow context of approaching retirement and/or in the withdrawal phase when one no longer has a paycheck. It also is not made with regard to complete systematic failure of our country or the world.

All one has to do is to flip around expectations about the stock market and that article makes a lot of sense. If there was a 60% chance you would experience a irreversible catastrophic loss of half of the stock investments... would you take the risk? I believe many would take the preservation of capital route!

Now one may make the observation that this scenario is not likely... and perhaps that is the case (no one really knows... but assume it). You... Yes YOU! Might cause it by making mistakes. Of course no (right minded) person is going to run head long into a big loss on purpose... all of us THINK we know what we are doing and that we (of all people) will not make a catastrophic mistake.

There seems to be a dichotomy between the two schools of thought (risk vs gain postures), and perhaps there are some differences. But I believe they are two sides of the same coin. I am glad that some academics are trying to give the other side of the story equal time.

I think it is good that these concepts are being discussed... as opposed to the current mantra by the investment banks and mutual fund companies of "naturally you should invest it in the stock market while in the withdrawal phase... your financial risks are manageable".... assuming no mistakes!

I believe the essence of the message from those academics is this: A rational person (if that exists) will take no more risk than they need to with money that they will need to live on. They may take some risk with true excess capital in hopes of bigger gains.

The horror stories that we all read about where people lost everything (through fraud, markets, mistakes, etc) is enough to motivate me to seek a solution to try to minimize the chances of catastrophic loss. Why not do it... I have excess capital!


I am choosing to create a base guaranteed income (guarantees such as they are). That way I have some form of redundancy and feel more confident about investing "my excess capital". I am willing to give up the chance of some gain (in an attempt) to immunize us from the unthinkable!

 

[ERD50]

Originally Posted by ERD50
But why is this so at odds with the FIRECALC runs?

I really was not trying to comment on their findings, or their findings relative to Firecalc, just on the idea that Van Harlow is a hack or lacking in sanity. Neither of these things is true. However this does not mean that the study is necesarily right, or that any plan is necessarily optimal.

Ha

I understand - my question was really in that same context. As in: Considering that I don't think these guys are hacks or insane, why is the report at odds with the FIRECALC results?

They can't both be right. FC shows a steady drop in success rates below ~ 35% EQ in most of the scenarios I've run. I suspect the diff is from Monte Carlo versus historical, but I'm not sure we have enough info in that report to determine that.

I personally don't have much faith in Monte Carlo for retirement portfolio analysis. I think the patterns of inflation, interest rates, bond and stock market returns just don't fit that sort of analysis. Maybe their pattern matching is far more sophisticated than just random numbers within a range and correlations with other returns, I dunno.

edit/add: Oh, and is there any rebalancing?

But since I've always planned on a fairly aggressive AA, I sure would like to understand this.

-ERD50

 

[Running_Man]

I see the differences being that Dr Harlow uses expected returns and then uses implied volatility to come to a calculated Net present value rather than use a sequence of actual past performances to measure the retirement portfolio balance.

In other words if I expect 6 percent real returns and volatility of 16% for stocks and 3 percent real return for bonds and 7% volatility and have future obligations of 7 percent of my starting portfolio what is the net present value as of today? The 3% real return for bonds is winning out because of the lower volatility.

Secondly I think although not made clear in the article, Dr Harlow is using the life expectancy with % chances of dying over a range for a 65 year old male rather than a 30 year retirement for all cases, increasing the net present value of the calculation by all the early dying.

The ability to get real returns of 6 percent for stocks and 3 percent for bonds seems unlikely to me in the present dividend/interest rate environment. But it makes for an interesting calculation.

 

[clifp]

The ability to get real returns of 6 percent for stocks and 3 percent for bonds seems unlikely to me in the present dividend/interest rate environment. But it makes for an interesting calculation.

Are you English, cause that may have been the understatement of the year. . Let see 10 year T-bills at 3% and total bond at 3.3.% and inflation is 2-3%. I also think that historically the returns for equities have been more than 3% higher than bonds. Anyway my AA is the polar opposite of his 10% cash/cds, 10% bonds, 65% stocks, and 15% real estate, commodities, and other.

 

[MasterBlaster]

All you have to do is reliably identify the bear market just before it starts, and just as reliably know when it's just about to end.

I consulted my Ouija board for your answer.

You need to buy at the bottom of the cycle and sell at the peak. That's the trick - Buy low sell high !

Whatever you do don't reverse this tried and true method of success.

 

[chinaco]

ERD - you should to reread that research paper.

His entire point is that tools like FIRECALC do not analyze certain aspects of the problem.


Here are a few quotes... just to make that point.

Rather than simulating returns to project the future value of a retirement portfolio (e.g., at age 85), the simulated returns are used as discount factors to compute the present value of future retirement cash flows. Mortality risk is captured by weighting these cash flows based on the probability of a person’s being alive at any point in the future.1 A positive RPV indicates the likelihood of having some assets left over at the end of life — the higher, the better. A negative RPV implies the possible or probable depletion of all retirement assets well before death — the lower the negative RPV, the worse.

A more important statistic gleaned from this RPV analysis is the expected retirement downside risk of $1.90. This metric is based on the standard deviation of the negative RPVs weighted by the probability of them occurring — a measure called semi-deviation. This is a more valuable assessment of the severity of the downside risk than just the possibility of depletion because it captures the severity of the unsuccessful outcomes, some of which could be devastating.3 For example, some outcomes shown in Exhibit 2 indicate adverse results as high as a negative $20, suggesting that there are combinations of market and mortality events that would have actually required 20% more in initial savings ($20 plus the original $100) at age 65 to completely fund a successful retirement at $7 per year.

It is worth noting that these overall spending rates are higher than normally indicated for retirees by financial advisors. Often at age 65, a 4% or 5% spending rate is quoted as a rule of thumb that should sustain an individual’s retirement. However, most financial planning tools do not incorporate the effects of mortality on expected spending levels. Here, with mortality included, a sustainable spending rate of $7 would be appropriate for males and $6 for females. On the other hand, if an individual expects to live to age 95, for example, the lower spending levels would be appropriate.4

Hopefully no one is putting too much faith in any calculators to divine their financial future in the security markets. They merely provide some insight to formulate an approach and plan. They do not provide your specific answer!

IMO - His paper points out some often overlooked issues and a different form of analysis that includes some of those issues. He is making a similar point as that of Zvi Bodie and some others. Take no more risk than is necessary with assets that will be needed to fund one's living expenses in retirement. He pegs the (low risk portfolio) equity level to be fairly low (5% to 25%). Now, he also suggests that those who have a bequest motive (and excess assets for a residual estate) may choose to invest those excess assets (and take some risk with the estate) with the hope of acquiring more for the estate... he suggests a 35% to 45% equity allocation might be appropriate.


I thought the paper was informative. Too bad it did not show illustrations for 55 yo early retirees.

 

[GaryInCO]

You need to buy at the bottom of the cycle and sell at the peak. That's the trick - Buy low sell high !
Whatever you do don't reverse this tried and true method of success.

Sound advice. I can state from personal experience that the "buy high sell low" approach doesn't work nearly as well.

 

[ERD50]

ERD - you should to reread that research paper.

His entire point is that tools like FIRECALC do not analyze certain aspects of the problem.


Here are a few quotes... just to make that point.

Hopefully no one is putting too much faith in any calculators to divine their financial future in the security markets. They merely provide some insight to formulate an approach and plan. They do not provide your specific answer!

IMO - His paper points out some often overlooked issues and a different form of analysis that includes some of those issues. He is making a similar point as that of Zvi Bodie and some others. Take no more risk than is necessary with assets that will be needed to fund one's living expenses in retirement. He pegs the (low risk portfolio) equity level to be fairly low (5% to 25%). Now, he also suggests that those who have a bequest motive (and excess assets for a residual estate) may choose to invest those excess assets (and take some risk with the estate) with the hope of acquiring more for the estate... he suggests a 35% to 45% equity allocation might be appropriate.


I thought the paper was informative. Too bad it did not show illustrations for 55 yo early retirees.

I have not read every word of the paper, but I did read the excerpts you quoted. It still leaves me wondering.

FIRECALC shows the higher EQ AA to provide a higher success %. Going down below 35% equities drops the success % for the scenarios I've run (including the default one). So why does this paper define 5~25% equities as a higher success rate?

Forget about how much you leave on the table ('positive RPV') - I'm talking about the risk of running out of money ('negative RPV)'. It seems to me that FC is all about negative RPV (failures). And FC says that something much higher than 25% equities is best (avoiding failure) for a pretty wide range of scenarios. I just don't get why this report differs in AA so greatly from what FC reports.

-ERD50

 

[chinaco]

I have not read every word of the paper, but I did read the excerpts you quoted. It still leaves me wondering.

...

I just don't get why this report differs in AA so greatly from what FC reports.

-ERD50

And you can guarantee you will not "get it" if you do not read it. Although, You probably won't fully understand (the issues you are concerned about) even if you do read it.

His model seems to be completely different and he is using different data (some variables appear to be derived then applied as base assumptions).

His portfolio is "specially optimized".... on and on.

One final methodological issue needs to be discussed. The asset allocations used throughout this report are optimized so as to minimize retirement downside (depletion) risk for any given scenario. Given the complex nature of the problem we are examining, we are forced to use a stochastic optimization process to seek out the best asset allocation mix for any set of assumptions. This approach is different than that used for conventional optimization in that thousands of simulations are made with each step of the algorithm in its search for the best solution.

Your observation is probably related to the fact that each of those tools and research papers look at the issues differently (trying to uncover or shed light on specific issues), include different data, and include certain assumptions.

His goal was to make a point.... He obviously was not randomly running simulations and accidentally happened across an "ah ha" type discovery.

The market behavior of the last decade has put some popular notions under more scrutiny.

The study suggests, in short, that the higher equity allocations used in many popular retirement investment products today significantly underestimate the risks that these higher-volatility portfolios pose to the sustainability of retirees’ savings and to the incomes they depend on.

I do not take any of those reports or any tool to be anything other than something that provides some insight about the problem... perhaps they suggest an outcome that could be more likely (assuming the model is followed and the past looks like the future).... and assuming one does not scr3w up somehow.

 

[Ken11]

I only scanned the paper- but this caught my eye:

"Of course, the duration of any specific plan or portfolio
will vary because of the uncertainty of how long one will
live. But RPV analysis captures and integrates all of these
dynamic components — flows, returns, and longevity —
and then discounts them into a positive or negative value​

expressed in today’s dollars"
-----------------

THis means the analysis involves some averages.
Thats why the 7% SWR is mentioned.
It seems that, for any individual, longevity risk remains uncovered.
The analysis seems to isolate "investment risk"
I dont know any smart person that recomments a 7% initial withdrawal rate.

Even just isolating the investment risk I'm still left wondering:
Was mindless annual rebalancing assumed?
How were the correlations that exist between the various returns/factors modelled?
Mote carlo suggests these correlations were not considered
(Note that Firecalc inherently does get this right.
The natural correlations are built into the Firecalc data.)
What maturity were the bonds assumed to have?

 

[MasterBlaster]

As I understand it, they do a multi-dimensional risk variance normalization where they normalize for the distribution of portfolio return risk, longevity risk, and sequence of withdrawal risk.

It's a model. FIRECALC is also a model. Maybe the model(s) is/are spot on. maybe it's not too good at predicting what to do.

What I can tell you though is that except for those retiring right before a bear market or before massive inflation hits, that the ubiquitous 4% SWR is way too conservative and severely limits your real-lifestyle in retirement.

The discussed model makes an attempt to risk-normalize that.