When is it time to pull in your investment horns and play it safe(r)?
That’s among the most common questions I hear from clients of my financial planning firm.
To illustrate this, meet our hypothetical couple, Bruce and Vickie. Both are 64, and for the past five-and-a-half years, they were almost 100% in stocks. They plan on retiring when they’re 67. After enjoying several years of 8% stock market growth, they were curious if they should get more conservative with their investments. In a nutshell, they are no longer comfortable with the risk and discomfort that comes along with that percentage of their portfolio being in the stock market.
That’s a legitimate concern and one that’s relevant to all investors who are either approaching retirement age or are already there. After all, when you’re in your 30’s, you have plenty of time for the market to recover from a significant market stumble. You have a lot less buffer room when you are in your early 60’s.
A significant hit to the value of your nest egg as you approach retirement (or during your retirement, even) may significantly reduce your financial resources for many, many years. This point is especially true if you decide to dip into your nest egg’s principle to make up for your diminished portfolio income.
So, yes, it’s prudent for most people to downshift their risk during this phase of their lives. If you’re 100% in stocks, you might want to consider dropping to anywhere between 80% to 40%. Your exact percentage should factor in your retirement time horizon, your penchant for market swings/losses and the amount you’ll need each year. If, for example, you’re 64, but don’t plan to retire until 70, you might not dial back your stock allocation as far as someone who plans to retire at 65.
As my colleague Walter Updegrave shares, “Unfortunately, whether due to complacency, failure to comprehend the risk they’re taking or some other reason, many people fail to dial back their stock holdings as they enter the home stretch to retirement. For example, an Employee Benefit Research Institute report found that prior to the financial crisis, when stock prices plummeted nearly 60%, more than 40% of 401(k) participants between the ages of 56 and 65 had over 70% of their account in stocks, and nearly 25% had more than 90% in equities.”
It’s essential across your entire investing career to keep tabs on your portfolio allocation and make adjustments accordingly. One way to set your allocation is to figure out how much income you’ll need from your investments during retirement, and work backward from there. Match your risk allocation to the income stream you’d like to have. And know that getting to the income level you’d like may require you to hold onto some riskier assets.
I’m a big fan of the 4% Rule, a rule of thumb developed by MIT’s William Bengen. His research on retirement investments revealed that a retiree could take 4% of their initial retirement assets and increase that amount every year to account for inflation, assuming a 50% to 75% portfolio allocation to stocks.
Published in 1994, Bengen’s study used data through 1992. In the study’s worst-case scenario, the money lasted 35 years. Furthermore, Bengen’s research showed that in nearly 80% of the periods tested, money would last over 50 years.
For a generation that had seen years of double-digit inflation and feared the buying power erosion in these periods, this study not only offered hope but also provided a tangible and achievable savings target.
But, just last year, the 4% Rule came under fire in a Wall Street Journal article that argued that 3% is a better withdrawal rate. So, my team and I decided to recreate Bengen’s study.
Our recreation incorporated retirement withdrawals beginning every year from 1929 to 2009 – or 82 separate retirement starting points. We used actual market data until 2017. After that, we ran multiple simulations with historically conservative average return estimates: 5% for stocks, 2% for bonds and 3% for inflation figures.
What did we find?
- Retirement funds last 50 years or more 70% of the time (58 of 82 scenarios).
- In the worst-case scenario, 30% of the time the money “ran out” after 29 years.
Bengen’s rule still brings clarity to the questions of what we can take out from our nest eggs, for how long and what kind of allocation a well-constructed portfolio will have. Additionally, it relieves the fearsome inflationary question.
Back to our original question, it’s fair to say that for someone in her 50s who’s hoping to retire in 10 years or so, a 100% stocks portfolio may be pushing it. So, it’s a good idea to reassess how much risk you want to have in your portfolio as you close on your planned retirement date. (And remember, Bengen’s study was based on a hypothetical allocation of 50% to 75% to stocks.)
Practically speaking, many people enter retirement with somewhere between 40% and 75% of their savings in stocks. But, there is no one-size-fits-all answer to how your portfolio should look as you’re making your entry into retirement. Your particular mix will depend on a number of factors, including how comfortable you are emotionally seeing your nest egg’s value bounce around with market fluctuations, how likely your nest egg to last given the size of the withdrawals you plan on taking, and what other resources (such as Social Security, pensions, home equity, annuity income, etc.) you will have to supplement your retirement budget.
Online, folks can find many risk-tolerance questionnaires. I tend to question these tools because people tend to answer in hindsight, and our goal is to turn our eyes to the future.
With that in mind, it may be helpful to reach out and work with a financial professional. Our team of Certified Financial Planners at Capital Investment Advisors can help you create a “glide path” into retirement.
Back to our hypothetical friends, Bruce and Vickie, it made sense for us to start a gradual reduction of the allocation in stocks. Because they want to retire in three years, we decided that a good stock percentage for their Golden Years was 60%. So, we planned to reduce their stock holding to 80% over the next year, 70% the following year, and then 60% when they hit their retirement. For them, that plan works.
The idea behind the “glide path” is to transition to a more conservative portfolio gradually. This way, you won’t find yourself entering retirement with such a large exposure to stocks that a market downturn would require you to dramatically scale back your retirement plans, or even force you to postpone retirement altogether!
Not everyone needs to decide on their exact “glide path” now. But, it’s good practice to start thinking about how your risk tolerance may change as the years go on.
One final point. Before you retire, you’ll also want to consider whether to continue to reduce your stock holdings during retirement. If the answer is “yes,” you’ll need to settle on the extent to which you’ll ratchet your stocks back.
Why would you continue to reduce your stock allocation even after you retire? I’m glad you asked. It’s because as you age, you may become increasingly anxious at seeing your nest egg lose value during periods of market turbulence. Nevertheless, you’ll want to keep at least some of your investments in stocks throughout your retirement, if only to help maintain the purchasing power of your savings should you live well beyond life expectancy.
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