Retirement Allocation Strategy Informed by P/E10
October 2, 2014 - Fundamental Valuation, Strategic Allocation
Does adjusting an asset allocation retirement glidepath according to a stock market valuation metric such as Shiller’s cyclically adjusted price-earnings ratio (CAPE ratio or P/E10) improve the outcome? In their September 2014 paper entitled “Retirement Risk, Rising Equity Glidepaths, and Valuation-Based Asset Allocation”, Michael Kitces and Wade Pfau investigate the interaction of pre-determined allocation glidepaths and P/E10 valuation based on long-run U.S. historical data. They consider the following strategy alternatives:
- Fixed equity allocations of either 45% or 60%.
- Declining (accelerated declining) equity glidepaths that start retirement at 60% stocks and reduce the allocation by 1% (2%) per year.
- Rising (accelerated rising) equity glidepaths that start retirement at 30% stocks and increase the allocation by 1% (2%) per year.
- A standalone dynamic valuation-based strategy with baseline 45% equity, raised (lowered) to 60% (30%) at the beginning of any year for which P/E10 is less than (greater than) 67% (133%) of its inception-to-date median. (See the chart below.)
- Unbounded and bounded combinations of declining or rising glidepaths and the dynamic valuation-based strategy, adding (subtracting) 15% from the equity glidepath at the beginning of any year for which P/E10 indicates undervaluation (overvaluation). Bounded combinations constrain equity allocation to a minimum 30% and a maximum 60%.
They consider both short-term bills (six months to a year) and long-term bonds (10-year) as complements to equities. They use overlapping 30-year intervals to approximate retirement outcomes. They focus on worst-case maximum sustainable real (inflation-adjusted) withdrawal rate over the 30-year retirement interval as the main strategy performance metric. Withdrawals occur at the beginning of each year, with the residual portfolio then rebalanced to target allocations. They assume withdrawals pay the taxes. Using Robert Shiller’s monthly data for U.S. stock market returns, associated P/E10, short-term bill yields (six-month commercial paper/one-year U.S. Treasury notes) and long-term bond yields (10-year U.S. Treasury notes or equivalent) during 1871 through 2013, they find that: Keep Reading