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The traditional asset allocation glidepath involves shifting client assets away from stocks and 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.
But rebalancing thwarts achieving client retirement goals.
It shifts from a higher yielding tax-efficient equity asset to a lower yielding tax-inefficient fixed income asset. In a previous article, I highlighted the positive impact a greater equity allocation can have over the several decades that clients will spend in retirement.
In this article, I 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 and let the portfolio drift towards a greater equity allocation.
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 to reduce 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.
In a traditional portfolio, 60% of the assets are allocated to stocks and 40% are allocated to bonds. If the stock part of the portfolio grows at a higher rate than bonds for a given year, the proportion of stocks will be greater than the original 60% at the beginning of the year.
Rebalancing resets the portfolio to the desired 60/40 allocation at the end of the year. This is done by 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 is 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. 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 rebalancing, let’s look at a case example of a client using a rebalancing strategy versus a non-rebalancing strategy.
Let’s consider a couple aged 55 that has $2.8 million in assets in a retirement portfolio that is split between a 60% allocation to stocks and a 40% allocation to bonds. At age 65, the couple decides to take withdrawals of $200,000 annually until age 95.
I simulated the returns for equity and bonds over the investment period under 1,000 different scenarios. I performed this under the rebalancing strategy and the no-rebalancing strategy. I 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 depleting the assets?
- 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 those questions, I can deduce whether the rebalancing strategy’s advantage of volatility reduction has any benefits in this couple’s investment goal. Below are the results of the simulation followed by an analysis.
The percentage chance of meeting a client’s retirement goals are roughly the same whether the client chooses to rebalance or not (77% versus 76%). But 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 is straightforward. The equity portfolio is both higher earning and more tax efficient. By not rebalancing, the portfolio drifts towards a greater equity position and can compound at a greater rate without the drag of selling assets to rebalance.
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.
Clearly the non-rebalancing strategy has definitive after-tax wealth benefits for the client due to shifting the portfolio slowly towards a greater equity position.
We can improve this equity tilt even further by taking retirement income withdrawals first from the bond position in the retirement until it is depleted, and then taking withdrawals from the equity allocation.
In our next example I’ll look at the effects of doing this.
Comparing the rebalancing strategy with the alternate non-rebalancing strategy that prioritizes withdrawals from bond allocation
In my next example, I used the same assumptions as the previous one with the only variation being that retirement income withdrawals are taken from the bond portion first until it is depleted and then from the equity allocation.
This further increases the tilt of the portfolio towards a greater equity position.
Below are the results of the simulation followed by an analysis.
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.
Conclusion
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 allocation helps minimize downside risk and volatility.
By properly utilizing bonds as a downside risk-protection tool in the course of retirement – and taking income withdrawals from bonds first in retirement – clients 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 retirement-income goals, but a large impact on the amount of after-tax wealth they pass on to their beneficiaries.
Rajiv Rebello, FSA, CERA is the principal and chief actuary of Colva Actuarial Services. Rajiv works with HNW clients, RIAs, family offices, estate attorneys, and CPAs to help them implement fiduciary life insurance, annuity, and alternative investment solutions in their practice to help increase clients’ after-tax returns and reduce volatility in their clients’ portfolios. Rajiv can be reached at [email protected].
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Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
