The traditional asset allocation glidepath involves shifting client assets away from stocks towards bonds as they near retirement. The idea behind this is that doing so reduces volatility in the portfolio and helps protect against sequence of return risk—thereby increasing the chance of helping clients meet their retirement income goals.
However this rebalancing actually hurts client retirement goals as it involves shifting from a higher yielding tax-efficient equity asset to a lower yielding tax-inefficient fixed income asset. In a previous article we highlighted the large impact a higher equity allocation portfolio can have over the several decades that clients will spend in retirement.
In this article we’ll show how the best way to utilize bonds in retirement is not to rebalance between stocks and bonds in retirement, but rather to draw down on the bond side of the portfolio first in retirement and let the portfolio drift towards a higher equity balance over time.
Doing this protects the client against sequence of return risk in the short-term while allowing the higher earning, more tax-efficient stock part of the portfolio to compound more effectively over time. Utilizing the bond portfolio in this way results in significantly more after-tax wealth left to clients while having minimal impact on the client’s chances of meeting their retirement income goals.
Introduction to Rebalancing
Rebalancing is used primarily as a method of reducing the volatility of the portfolio. In rebalancing, the constituents of the portfolio are bought or sold at regular intervals such that their percentages relative to the portfolio value is maintained at a certain level.
For example, in a traditional portfolio, 60% of the assets are allocated to stocks and 40% are allocated to bonds. So for example, if the stock part of the portfolio grows at a higher rate than bonds for a given year, the proportion of stocks will be higher than the original 60% at the beginning of the year.
What the rebalancing approach then aims to do is reset the allocations to the desired 60/40 allocation at the end of the year. This is done by simply selling some stocks and using the cash generated to buy more bonds thus maintaining the 60/40 allocation.
One might wonder how taking money out of an asset that grows at a higher rate and transferring it into an asset that grows at a lower rate is a good strategy. It seems counterintuitive to the idea that money should remain in assets that grow at a higher rate. But an asset offering a higher rate of return often comes with higher risks and hence, higher volatility.
The idea of rebalancing is to optimize the return of the portfolio relative to the volatility. So while the stock portion of the portfolio is providing the higher returns, the bond part of the portfolio is providing the reduced volatility. What is often overlooked in this strategy, however, is the unfavorable tax implications and lower yields of investing in fixed income assets versus the tax advantages and higher returns provided by the equity assets.
Comparing the Rebalancing Strategy with the No-Rebalancing Strategy
To understand the adverse effects of the rebalancing strategy, let’s look at a case example and look at the effects of whether the client utilizes a rebalancing strategy versus a non-rebalancing strategy.
Let’s consider a couple aged 55 that has $2.8M in assets in a retirement portfolio that is currently split between equity and bonds with a 60/40 allocation respectively. At age 65, the couple decides to take withdrawals of $200k from the portfolio annually until age 95.
We simulate the returns for equity and bonds over the investment period under 1000 different scenarios. And we perform this under the rebalancing strategy and the no-rebalancing strategy. By doing this, we can compare the performance of the two strategies by asking the following questions:
- What is the success rate of each of the strategies? That is, in how many scenarios would the couple be able to withdraw money from the fund without it running out of money?
- What is the median after-tax fund value at the end of the investment period? How does it compare with the other strategy?
- What is the volatility of the returns under each of the strategies?
By answering these questions, we can then try to deduce whether the rebalancing strategy’s advantage of volatility reduction has any benefits in this couple’s investment goal. Given below are the results of the simulation followed by an analysis of the results.
Performance of retirement portfolio under rebalancing and no-rebalancing strategy
at Age 95
at Age 95
*Withdrawals are taken out based on the allocation of Equity and bond at that time. I.e., in the rebalancing strategy, withdrawals are taken such that the 60/40 allocation is maintained. In the no rebalancing strategy, withdrawals are taken based on the prevailing allocation %s in equity and bond.
In the above table we can see that the percentage chance of meeting a client’s retirement goals are roughly the same whether the client chooses to rebalance or not rebalance (77% vs 76%). However, what is markedly different is the amount of after-tax wealth left to the client’s beneficiaries.
By choosing not to rebalance, the client leaves 26% more after-tax wealth ($7,661,558 vs $6,072,735) to their beneficiaries at age 95.
Furthermore, the volatility of the portfolio is reduced by using the non-rebalancing strategy as we can tell from the higher Sortino ratio of the non-rebalancing strategy (2.85 vs 2.03).
The rationale for these results are fairly straightforward. The equity portfolio is both higher earning and more tax-efficient. By not rebalancing the portfolio, over-time the portfolio drifts towards a higher equity position and is able to compound at a greater rate without the drag of selling assets to rebalance the portfolio.
Keep in mind that when a portfolio is rebalanced and assets are sold, taxes have to be paid on the gains. This is a further drag on the portfolio that occurs with the rebalancing strategy but not with the non-rebalancing strategy.
So clearly the non-rebalancing strategy has definitive after-tax wealth benefits for the client due to shifting the portfolio slowly over time towards a more equity position.
We can improve this equity tilt even further by taking retirement income withdrawals first from the bond position in the retirement until the bond portfolio is depleted, and then taking retirement income withdrawals from the equity portfolio.
In our next example we’ll look at the effects of doing this.
Comparing the Rebalancing Strategy with the Alternate Non-Rebalancing Strategy that Prioritizes Withdrawals from Bond Portfolio First
In our next example we’re going to use the same assumptions as the previous one with the only variation being that retirement income withdrawals are taken out of the bond portfolio first until the bond portfolio is depleted and then from the equity portfolio.
This further increases the tilt of the portfolio towards a greater equity position.
Given below are the results of the simulation followed by an analysis of the results.
Performance of retirement portfolio utilizing rebalancing and no-rebalancing with bond withdrawals first
at Age 95
at Age 95
bond portfolio first)
*In the rebalancing strategy, withdrawals are taken such that the 60/40 allocation is maintained. In the no rebalancing strategy (alternate), withdrawals are taken from bond first until it is depleted and then from equity.
In the table above we see that the median portfolio value is much higher than the rebalancing strategy resulting in 80% more after-tax wealth ($10,925,408 vs $6,072,735) with minimal impact on the client’s ability to meet their retirement income goals.
Clients will often live 20 to 30 years in retirement. The equity portion of the portfolio is the part that generates long-term wealth while the bond portion of the portfolio is the part that helps minimize downside risk and volatility.
By properly utilizing bonds as a downside risk protection tool in the course of retirement construction—and making income withdrawals from the bond portfolio first in retirement—clients can allow the higher earning, tax-efficient equity portfolio to compound at a greater rate.
Doing so has minimal impact on the client’s chance of meeting their own retirement income goals, but a large impact on the amount of after-tax wealth they pass on to their beneficiaries.