The Glidepath Obfuscation

Much attention has been given to the matter of the proper glidepath for 401(k) participants.  Most recently Rob Arnott, founder of Research Affiliates, has weighed in on this subject.  Arnott’s criticism of any mechanistic glidepath,[1] was in turn criticized by Steven Wallman[2] for missing the point that a glidepath reduces risk.   Arnott then accused Wallman of missing the point because “the numbers are what they are” and the numbers show a reduction in return that offsets the reduction in risk.  Well, Arnotts contrived numbers may show that but in my opinion, they are both missing the point.  To paraphrase Einstein, they are trying to solve today’s problems with outmoded methodologies of the past.

The main flaw in their logic is that both of them choose to ignore the return that each 401(k) participant needs to earn on their assets in order to meet a future payout, namely, retirement income. Both gentlemen choose not to estimate this return that we call the Desired Target Return® or DTR®.  Ipso facto, ignoring the DTR makes it impossible to calculate the risk of falling below the DTR or the potential to exceed that return.  In other words, they have identified the wrong problem which leads to the wrong solution to the real problem.

Framing portfolio management as an asset management problem leads both men to focus on which assets to use to achieve the highest terminal wealth.  Wallman says young people should start out with stocks and end up in bonds to reduce the risk of a hit to terminal wealth.  Arnott says investors would more often have ended up with greater wealth if they started out with bonds and ended up in stocks.  We agree with Wallman that 401(k) participants who wanted to retire in 2008 should not have been heavily weighted in stocks in 2007.  We also agree with Arnott that age alone should not determine the asset allocation between stocks and bonds and starting to decrease equity 20 years before retirement is ridiculous.

But gentlemen, investing is an asset-liability management problem, not an asset management problem.  Stocks and bonds are only the vehicles we use to get investors from where they are financially to where they need to be at some point in the future.  Your argument is as foolish as debating whether or not people should begin every trip by air or by bus.  The proper combination and timing of vehicles depends on where they are going and where they are starting from, not on their age or their preferences.

Lest we be misunderstood, we have the greatest respect for Rob Arnott and his understanding of financial theory.  He was, after all, the editor of the Financial Analysts Journal.  But let’s see how his adherence to the MPT framework leads him astray as regards a much needed solution to managing 401(k) plans for participants.

Critique:

  1. Arnott uses 141 years of stock and bond market returns to make the case that “Prudent Polly”, who begins at 22 years of age with an 80% equity position and at age 30 begins her descent in equity until age 63, at which time, she liquidates her portfolio and purchases an annuity with the funds she has accumulated.  With 20/20 hindsight he shows she could have done better by maintaining a 50/50 mix of stocks and bonds or steadily increasing equity exposure.  This implies history is going to repeat itself, an assumption he later decries.  We believe Bradley Efron’s “Bootstrap” procedure is a superior way to describe future return distributions and provide evidence in our paper titled, “Portfolio Navigation”  that a glidepath longer than five years is like starting your descent into Kennedy Airport when you are over Chicago.
  2.  Arnott uses three measures of risk to make his point: the standard deviation of returns for the past 141 years, the range of returns from the 10th percentile to the 90th percentile and the ratio between the 10th and the 90th percentiles.  However, none of these risk measures incorporate the return Polly needs to earn in order to replace a predetermined percentage of salary. Furthermore, we have shown that reliance on the probability of a low return for capturing the risk that Polly is facing is inadequate and misleading.[3]  The disastrous results of using Value at Risk (VAR) in 2008 testify to that.   We believe a relevant measure of risk should capture the risk of not achieving the retirement income she needs and propose deviations below her DTR as a more appropriate risk measure.
  3. Arnott then says it is much more important for Polly to know “how large a lifetime inflation-indexed annuity she can buy at retirement” because that is “an important measure of success.”  In other words, Polly is stuck with whatever amount of money she is lucky or unlucky enough to accumulate at retirement, because nobody bothered to estimate how much she would need to replace, say, 70% of her salary at retirement.  This implies the goal is to make as much money as she can.  We believe the goal is to replace 70% or more of her income and the way to measure that is to estimate the potential to exceed her DTR.
  4. Arnott then calls attention to his assumption that she was only saving $1000 per year and nothing can make up for investing too little too late.  We agree, but believe an appropriate methodology would notify her periodically how much more she needs to invest, as we do in our Mapvest® report.
  5. Arnott then attempts to correct for assuming the past is prologue by randomly drawing annual returns from the 141 years of annual returns to generate a better picture of uncertainty.  However, first he attempts to make the outcomes look more like today’s by assuming “ risk in the future resembles the past but returns in the future are lower.”  This ad hoc adjustment seems to imply his methodology is flawed. Furthermore, only selecting annual returns that did happen cannot account for what has never yet happened.  But the bootstrap procedure does address this without subjective adjustments.  We believe the methodology we used in our paper “Portfolio Navigation™” is a superior way to compare strategies and leads to a more reliable way to manage Polly’s portfolio over time.

Summary and conclusions:

Instead of framing portfolio management as an asset management problem where the solution is to maximize wealth and whoever makes the most money wins, we believe one should frame it as an asset-liability management problem.  From this perspective, the solution more closely resembles a navigation problem that will transport Polly’s portfolio from where it is to where it needs to be at some specified time in order to meet or exceed an estimated payout schedule.

Bickering over trivial matters like the glidepath only serves to obscure the real problem.  Target date funds are a dismal failure, yet the most popular choice for defined contribution plans.  Therefore, instead of trying to fix a seriously flawed methodology, we should all work to scrap it for a superior approach oriented toward accomplishing the investor’s real goal of replacing income at retirement.  Making money is not the goal in and of itself.  Making money is how one accomplishes the goal of meeting or exceeding some specified future payout. How much money is needed and how much risk is involved can only be determined if one bothers to estimate the DTR. This is a critical variable that should no longer be ignored.


[1] RA Fundamentals, September 2012

[2] www.fa-mag.com, November 19,2012

[3] The Sortino Framework for Constructing Portfolios, pg 27.

Download this post as a pdf:  The Glidepath Obfuscation

About Frank Sortino

Frank Sortino is finance professor emeritus from San Francisco State University and Director of the Pension Research Institute which he founded in 1981. For 10 years he wrote a quarterly analysis of mutual funds for Pensions and Investments Magazine and he has written two books on the subject of Post Modern Portfolio Theory. He has been a featured speaker at many conferences in the U.S., Europe, South Africa, and the Pacific Basin. Dr. Sortino received his Ph.D in Finance from the University of Oregon and has carried out research projects with many institutions like Shell Oil, Netherlands and The City and County of San Francisco Retirement System.
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