Portfolio Advice Should Include Savings

Savings Matter At Least As Much As Allocation Strategies

Kurt Winkelmann, Raghu Suryanarayanan, Ferenc Szalai

Portfolio decisions comprise not only decisions about how to invest - the investment portfolio - but also about how much to invest - contributions (or savings). Traditional portfolio advice has the tendency to focus on the former and largely ignored the latter. In our view, savings decisions - how much and when - matters as much as the allocation strategy itself in improving financial wealth outcomes.

Our starting point is the equilibrium framework we discussed in our previous note. As shown in the note, our framework differs from the standard one-size-fits-all approach and provides a robust foundation to differentiated portfolio advice by taking seriously the ideas of:

In our framework, individuals accumulate wealth during working life by deciding how much to save (or spend), and how to invest those savings in a combination of risky and risk-free assets, given macroeconomic conditions (both current and future prospects), their attitude towards risk, and their income. After retirement, assumed to be at age 65, they spend out of their accumulated wealth. Finally, all individuals’ savings and asset holdings should add up to aggregate savings and aggregate market cap weights for each asset class.

Accordingly, individuals vary in their portfolio allocations, following a glidepath. While holding assets in their market cap weights (with a 65/35 risky assets/bonds split) could make sense around retirement age (in the US), younger individuals can bear more macro risk with growth-sensitive allocations - earning a higher expected return. Older individuals are more sensitive to macro risk and tilt towards growth-defensive assets and government bonds - with lower returns but also less risk.

By contrast to standard practice that tends to fix the savings rate at a constant rate (often too low and arbitrary), our framework implies that savings and contributions should also vary, primarily by age, and be aligned with macro conditions. Exhibit 1 shows the savings glidepath that is aligned with the allocations glidepath. The savings (contributions) rate stays flat from early- to mid- working life at a meagre 5% per year. Spending accounts for much of the typically small earnings made at that stage, the retirement horizon is still distant, and risky asset holdings have higher expected rates of return. However the rate then increases on a continued basis through retirement to help maintain a similar level of spending pre- and post-retirement, finally reaching about 32% (on average across investors).

Exhibit 1 - Navega Model Implied Savings Glidepath

Navega Model Implied Savings Glidepath
Source: Navega Strategies LLC Research

Exhibit 1 also shows that the savings rate should depend on expected macro conditions. For example, under a scenario envisioning a prolonged decline in real economic growth trend, savings rates should increase. Interestingly, the two significant macro events of the last 70 years - the 2008 Global Financial Crisis (GFC) and Covid-19 - have both been associated with increases in the average personal savings rate. As a historical example of a significant continued decline in trend growth, the GFC case is particularly revealing. While US real GDP growth decreased on average from 2.5% (average from 2000 to 2008) to 1.5% (average from 2009 to 2019), the average personal savings rate in the US increased from 4% to 7% over the same periods. Our models help decode these apparent linkages between savings and macro risk. According to our models, a prolonged period of slow or lower real growth erodes both real investment returns and real income growth, leading to a knock-on effect on accumulated wealth. Increasing the savings rate help compensate for the loss of income.

Exhibit 2 illustrates this point. According to our models, should savings and allocations remain unchanged (i.e. still aligned with our baseline macro scenario), a secular 100bps decline in trend economic growth relative to our baseline could result in a -37% loss in retirement wealth (relative to the current baseline macro scenario). Simply re-aligning portfolio allocations (shifting towards less risky assets, in this case) would not help. While barely improving wealth outcomes in early- and mid- working life, retirement wealth could fare even worse, with an expected loss over -40%. However, adjusting and increasing the savings rate through working life, in addition to de-risking the portfolio allocations, could help limit the retirement loss to -28%. 

Exhibit 2 - Aligning Savings with Macro Conditions Help Improve Retirement Wealth Outcomes

Aligning Savings with Macro Conditions Help Improve Retirement Wealth Outcomes
Source: Navega Strategies LLC Research

Moreover, as shown in Exhibit 3, adjusting savings rates could also help mitigate shortfall risks (as measured by the 5th percentile of the wealth distribution). Again, simply adjusting the portfolio allocations would only barely help. Aligning the savings rate, however, could even help reduce shortfall risk (relative to the current baseline macro scenario) by as much as 20% on average through working life. Around retirement, the incremental increase in shortfall risk would be only about 5%, relative to the current baseline macro scenario, by contrast to the 40% increase potentially incurred by leaving savings and allocations unchanged or only re-aligning the portfolio allocations.

Exhibit 3 - Aligning Savings With Macro Conditions Help Reduce Wealth Shortfall Risk

Aligning Savings With Macro Conditions Help Reduce Wealth Shortfall Risk
Source: Navega Strategies LLC Research

Our equilibrium, macro-based models and framework for differential portfolio advice allow investors to align savings and allocation strategies with changes in long-term macroeconomic conditions, and trace the impact on wealth outcomes in a systematic fashion. Our models indicate that, when faced with the prospect of lower growth,  focusing on investment returns alone may not be enough to improve wealth outcomes near retirement. Investors should also revisit their savings strategy to help compensate for the loss of income. Taken together, adjusting the savings rate and tailoring allocation strategies to macro views markedly improve near retirement wealth outcomes.

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