
Adopting the Smile Approach to Retirement Planning
The Problem: Sequence Risk Meets Longevity Risk
David and Marie are a 65-year-old married couple preparing for retirement. With $1 million spread across Defined Contribution (DC) pensions, RRSPs, TFSAs, and non-registered accounts, they feel a quiet contentment about reaching this financial milestone. However, recent events have given them pause. The inflationary surge that followed the global response to the COVID-19 pandemic reminded them how quickly financial conditions can shift. While 2024 brought a recovery in their investments, they find themselves questioning whether their portfolio can sustain them through the decades ahead.
The challenge they face is multifaceted: how to mitigate the potential impact of market downturns early in their retirement (sequence of returns risk) while also ensuring their savings will last as long as they do (longevity risk). They are aware of standard approaches, such as maintaining a fixed asset allocation—60% equities and 40% fixed income is often cited—or adopting a lifecycle model that significantly reduces equity exposure as retirement approaches. Yet they are uncertain whether these approaches will adequately address the twin risks they face.
What would happen, for example, if a significant market decline occurred just as they began their planned withdrawals? How might that early setback affect their ability to meet essential expenses or preserve funds for later years?
Why Traditional Solutions Fall Short
While money is often portrayed as a matter of mathematics and probabilities, it is deeply emotional, especially as we approach retirement. Steady incomes provide a sense of stability during working years; drawing on the assets accumulated over decades introduces an unwanted degree of uncertainty. Traditional approaches often fall short of alleviating the resulting anxiety.
Static Asset Allocations
Sticking to a fixed allocation, like 60% equities and 40% fixed income, or the classic 50/50 portfolio used by William Bengen in his “4% Rule” (a term he didn’t actually use), lacks the flexibility to respond to changing needs and risks. The following chart illustrates this approach from ages 25 to the end of life:
Lifecycle Model Glide Paths
This approach, commonly found in target-date funds that are the default in DC pension plans and group RRSPs, reduces equity exposure over time. However, it often leaves retirees underexposed to growth in later years, heightening inflation and longevity risks.
The outcome for many retirees is that they end up too conservative too soon or too aggressive when risk should be reduced. An example I saw repeatedly when supporting DIY investors at one of the Big Bank “Direct Investing” divisions was retirees reducing their equity exposure to zero by investing only in GICs. While safe early on, inflation will almost inevitably eat away at their purchasing power, leaving them with inadequate funds in their later years. While this isn’t quite as radical as an all-GIC portfolio, here’s one example based on Vanguard’s (U.S.) Target Retirement Fund series. This chart assumes a retirement age of 65, when the portfolio drops to 50% equity. You will notice one more step past age 65. At age 70, the portfolio drops to 36% equity.
The Smile Approach Offers a Balanced Solution
What is the Smile?
The Smile approach, if it makes you happy, is a byproduct of how you rebalance your portfolio over time, rather than a description of your emotional state.
As you noticed from the line chart above, the Static Asset Allocation approach is a straight line representing a steady allocation to equities throughout one’s life. The Lifecycle Model shows a declining “glide path.” Finally, a U-shaped “Smile” equity trajectory (see below) shows a decline as one approaches retirement and then an increase after retirement begins.
As you will see, it is characterized by the following:
- High equity allocation during accumulation years.
- A sharp reduction in equities leading up to retirement to protect against sequence risk.
- A gradual increase in equity exposure post-retirement to address longevity and inflation risks.
Why The Smile Approach Works
Let me express a caveat here in that the line chart of the Smile Approach, below, is my own creation; the precise percentages in the equity portion of the portfolio are not based on a recommended Smile path from an investing guru or an existing fund company’s asset allocation, nor is it a specific recommendation. I first heard about the Smile Approach from Wade Pfau, an American retirement income guru if ever there was one.
You can see how I set a path of a 100% equity portfolio from ages 25 to 44 and then gradually reduced the equity percentage until it reached 50% equity/ 50% fixed income at ages 64 and 65. Then, from age 66 onward, I gradually increased the equity percentage to 60% at age 70 and held steady from there.
Zooming in a little closer, it looks something like this from ages 60 to 70:
I will admit that it is more of a shallow V than a Smile, but I trust you get the point.
Sequence Risk Mitigation
The pre-retirement dip in equities shields the portfolio during the most vulnerable period (early withdrawals). While returns are not guaranteed, even from fixed income, the tendency is for equities to be much more volatile, with larger returns over the long term, but with more frequent episodes of significant downturns in the short term. For example, the 5-year standard deviation of XBB, the iShares Core Canadian Universe Bond Index ETF, is 6.6%, and that includes the dramatic impact of inflation in 2022. On the other hand, XEQT, the iShares Core Equity ETF Portfolio has a 5-year standard deviation of 13.6%. Exposing your investment portfolio to less volatile investments as you enter retirement is one of the ways to reduce sequence of returns risk.
Longevity Protection
Instead of steadily decreasing to an even lower equity allocation from age 65 onward, the Smile approach assumes a post-retirement increase in equities, which restores growth potential, a reasonable concern as the portfolio needs to last 30+ years.
Rationale
There are at least two reasons why the Smile approach makes sense.
- During the early years of retirement, withdrawals are funded from a lower-risk portfolio, reducing the impact of potential market downturns.
- Later in life, when life expectancy decreases and inflation risk rises, a higher equity allocation supports growth sufficient to meet anticipated expenses even as relatively low inflation rates work their corrosive effect on the buying power of a dollar.
How the SMILE Approach Works in Practice
Let’s elaborate on the strategy for David and Marie using the provided glide path.
Starting portfolio allocation (age 65):
- 10% cash (including short-term GICs within the fixed-income allocation)
- 40% fixed income (including bonds and GICs of 1-5-year terms)
- 50% equities (15% Canadian, 21% US, 10% international developed, 4% emerging markets)
This allocation balances growth potential with a strong focus on stability to mitigate early sequence-of-return risks.
How might someone approach the Glide Path who is just starting their investing career?
Early career (ages 25–44)
100% equities. Focus on long-term growth through globally diversified equity investments.
- Equity Allocation: 30% Canadian, 43% US, 20% International Developed, 7% Emerging Markets.
Mid-career (ages 45–60)
Begin a gradual reduction in equity exposure, tapering to 60% equities by age 60, with fixed income (including cash and GICs) increasing to 40%.
Retirement transition (ages 61–65)
Continue reducing equities to reach 50% at age 65, alongside 50% fixed income. This conservative allocation limits exposure to market downturns as withdrawals begin.
Early retirement (ages 65–70)
Gradually increase equity exposure to 60% as sequence risk diminishes, balancing growth with longevity risk.
Later retirement (age 71+)
Maintain a steady 60% equity allocation to hedge against inflation and preserve purchasing power.
Others might want to stretch out the bottom of the Smile or give a bit of a lopsided grin to the changes in the portfolio, perhaps waiting until age 75 to get back up to a 60% equity portfolio. These choices depend on your ability, willingness, and need to take risk in your retirement portfolio.
Risk management tools
GIC Ladder
Within the fixed-income portion of your portfolio, you may wish to set aside a portion in a GIC ladder to provide stable, predictable income during the early retirement years.
Global Diversification
As was shown in the model portfolios above, when it comes to equities, it is important to diversify geographically to reduce overall volatility. There may have been a time when Canadians would limit themselves to Canadian and US equity exposure. But that time is long gone. Globally diversified options abound, and we should do what we can to reduce the risk of relying too much on the investment options of any one country.
Emergency Fund
While you may not think of an emergency fund as a part of your investment portfolio, having one available serves the necessary role of helping to reduce the need to liquidate your long-term investment assets if you have unexpected expenses.
Why the Smile Approach Can Bring Peace of Mind
Retirement planning isn’t just about numbers—it’s about confidently living the contented life that you’ve envisioned. The Smile approach combines thoughtful allocation strategies with adaptability, offering both emotional and practical benefits for retirees.
Confidence in early retirement
With $1 million in investments, income from the Canada Pension Plan and Old Age Security, and essential spending of $60,000 per year, our retiree couple, David and Marie, can comfortably cover their necessities and enjoy an additional $40,000 in discretionary expenses. By increasing their allocation to cash and fixed income early on, they have reduced their risk from the immediate impact of market downturns, allowing them to travel, spend time with family, or pursue hobbies without constant financial anxiety.
Security for later years
As they transition into mid and late retirement, the Smile approach increases equity exposure, ensuring the portfolio grows to keep pace with inflation. This growth safeguards their purchasing power, reduces the risk of outliving their savings, and provides a financial cushion for unforeseen medical or caregiving expenses.
Flexibility
Life in retirement is full of surprises, and using the more dynamic Smile approach allows for adaptation to evolving needs. By balancing stability through fixed income with growth through equities, this strategy provides the confidence to weather economic changes while allowing for adjustments as priorities shift over time.
Retirement isn’t just about avoiding risks—it’s about managing them wisely. The Smile approach offers a dynamic, thoughtful strategy that lets you enjoy retirement while preparing for the future. With a balanced portfolio and a clear glide path, you have greater potential to navigate the challenges of retirement while experiencing the joys that come with this new chapter.
This is the 276th blog post for Russ Writes, first published on 2025-01-20
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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, tax, or legal decisions.