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Howard Gold's No-Nonsense Investing

Howard Gold

April 25, 2014, 7:01 a.m. EDT

What if retirement advice is completely backwards?


By Howard Gold






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Pfau’s theory, which he and co-author Michael Kitces tested in a 2013 paper using 10,000 simulations, is that investors should reduce their share of equities by the time they retire, which he views as the point of maximum risk.

“The stock allocation is the lowest at the point when lifestyle spending goals are most vulnerable to absolute losses in wealth (the retirement transition itself),” Pfau and Kitces wrote.

But they discovered retirees would be better off if they steadily increased their stock holdings throughout their retirement, because “the equity exposure is greater by the time subsequent good returns finally show up. In turn, this helps to sustain greater retirement income over the entire time period.”

In two related papers, Arnott and his Research Affiliates colleagues used stock data going back to 1871. That encompassed 101 different 41-year periods, each roughly the length of a working life.

They tested three different scenarios: the traditional approach, a balanced 50-50 mix of stocks and bonds, and what they call an “inverse glide path,” in which investors increase their share of stock throughout their careers.

Their findings? The traditional approach produced a smaller nest egg than either the balanced approach or the inverse glide path, which had the best returns. That finding, Arnott added, also held true for 19 countries with 110 years of data.

Why does it work? Because, as Arnott told me in a phone interview: “By investing more aggressively when you have more money, you’re likely to have greater wealth in retirement.” That’s because, he explained, stocks outperform bonds over the long run, and “the risk of owning stock goes down sharply as the time horizon gets longer and longer.”

That may be true, and it’s hard to argue with statistics, although, to be sure, both studies are based on probability theory, which as we learned during the financial crisis has its, ahem, weaknesses. Neither of those papers included actual retirees.

And that’s where I run into problems, because investors often don’t do what academic research says is optimal, or even what common sense says is good for them.

In fact, they frequently do the opposite. An authoritative research study of investor behavior over 30 years by DALBAR found: “Attempts to correct irrational investor behavior through education have proved to be futile. The belief that investors will make prudent decisions after education and disclosure has been totally discredited.”

Try explaining “inverse glide paths” to people who can’t even learn to buy low and sell high.

Research has shown that people are particularly sensitive to losses, and as we age, we don’t handle risk as well, either. Plans like Pfau’s and Arnott’s are only for the very, very few sophisticated investors who have demonstrated true risk tolerance in the real world.

Both Arnott and Pfau agreed that the best solution for many people may be converting parts of their retirement nest egg into an annuity-like product that provides guaranteed monthly income and takes risk management out of retirees’ hands.

Keeping it simple is often the best policy, even if it doesn’t produce the biggest returns. Most of the time, good enough works just fine.

Howard R. Gold is a MarketWatch columnist and founder and editor of GoldenEgg Investing , which offers retirement investing plans and free market commentary.Follow him on Twitter @howardrgold .

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