Do Risk and Retirement Mix?
Adding more stocks to your income plan may help offset low interest rates and inflation.
We live in unusual times, with interest rates at historical lows but likely to rise in the not-too-distant future, stocks trading at what some consider elevated levels driven by a years-long bull market, and investors scouring the pronouncements of central banks for clues to what may happen next. However, one thing remains unchanged – those in or near retirement still have to map out a prudent strategy for generating reliable income in the years ahead.
Traditionally, investors have relied primarily on bonds and other fixed income securities to generate retirement income using fairly rigid formulas. For example, reduce your exposure to stocks over time by maintaining a percentage allocation to bonds that matches your age, don’t withdraw more than an inflation-adjusted 4% from your portfolio annually, and don’t touch your principal.
That approach served those who retired during much of the past 30 years fairly well, partially because interest rates were much higher then and partially because they also were declining steadily. Those conditions made it possible for bond investors to collect attractive interest payments, while often seeing their investments appreciate, because bond prices move inversely to interest rates.
However, different times call for different thinking, and some researchers and investment professionals now recommend that retirees maintain a significant allocation to equities throughout retirement, perhaps even increasing that allocation as they age.
The case for stocking up on equities
At first blush, this seems to run counter to what many of us have generally thought about retirement – we need to minimize risk by staying mostly in “safe” investments. But the foremost worry of many retirees is that they might outlive their money – what’s known as “longevity risk” – so any retirement income plan must squarely address that risk. Holding a higher proportion of equities, which offer the possibility of capital appreciation, may help offset the steady drain on retirement portfolios caused by withdrawals and inflation. In addition, investors need to be aware that bonds as a whole may decline in price if interest rates trend upward over the course of a long retirement.
Of course, not all equities are created equal. Larger cap stocks are generally considered less risky than their small/medium counterparts or international stocks, for example. Since retirees need reliable income, they may want to focus on large, well-established companies with a proven history of paying and growing their dividends. Dividends have been meaningful contributors to the total performance of stocks over time, and dividend-oriented stocks also have held up better when the market has declined. Bear in mind, though, that dividends aren’t guaranteed, as bond payments are.
Think ahead about volatility
As with any investment decision, there’s a risk-reward tradeoff here. Equities historically have been more volatile than bonds, so if you allocate more of your retirement portfolio to stocks, you have to be prepared to weather periods of volatility. It’s critical that you work to invest in a portfolio that fits your risk tolerance so you are able to stay the course when the inevitable gyrations arrive. Don’t “stretch” trying to obtain higher yields – realistic investment parameters and your risk tolerance should dictate the level of income your portfolio can generate. Also, keep in mind that bonds can be volatile too, especially when interest rates rise. While no one can predict with certainty what interest rates will do, a steady increase in rates will put downward pressure on bond prices.
One option that may help you keep your cool is maintaining a cash reserve (or other sources of liquidity) equal to several years’ worth of living expenses – we can help you decide how much. Although you won’t be earning much on that money, you also won’t feel pressured to liquidate some stock holdings when prices are down in order to meet expenses.
Consider all your income sources
In thinking about how much of your retirement portfolio you might allocate to stocks, it’s helpful to first step back and consider the nature of your income sources. For example, most retirees receive regular Social Security benefits, which can be thought of as fixed income. Pensions, annuities and other sources of reliable income also go in the same column. Comparing income from secure sources to your overall expenses will provide you with a framework for determining how your retirement portfolio should be allocated.
Creating the appropriate stock/bond/cash allocation is part of a bigger picture that includes accepting things you cannot control, such as how long you’ll spend in retirement and what the markets and inflation will do during that time. We can help you estimate how your portfolio will react in certain hypothetical circumstances and make adjustments as needed. But since worrying about areas you can’t control isn’t productive, it’s wise to focus on the things you can influence –like how much you spend and how you invest your retirement savings.
Glide paths, sequences and U-turns
Determining the retirement strategy that’s right for you requires assessing a number of risks and deciding how best to mitigate them. Because stocks historically have been more volatile than bonds, the traditional approach has been to gradually reduce exposure to equities over time, creating what’s known as a “glide path” whereby bond allocations reach their maximum when the investor retires – their “target date.”
While many investment professionals remain comfortable with that strategy, others point out that with interest rates likely to rise in the future, retirees with large allocations to bonds could see the value of those holdings decline. Allocating more to equities may help mitigate that risk, but doing so also increases what’s called “sequence of returns” risk – essentially the possibility that you retire at about the same time that stocks head south. Several years of negative returns at the outset of retirement can be tough to recover from, especially if that’s when your allocation to stocks is large, meaning that losses take a bigger bite out of your overall nest egg.
To address that risk, some experts now advocate dialing back your allocation to stocks as you approach retirement, leaving it at that level for a few years and then raising it as time goes by – creating a “U-turn glide path.” Under this strategy, investors might reduce their stock holdings to between 20% and 50% as they enter retirement, stay at that level for a while, then increase their equity allocations by a percentage point or two every year. This is intended to reduce the chances of incurring major losses at the beginning of retirement while also allowing for the possibility of capital gains later.
As you can no doubt see, carefully monitoring and managing your portfolio, including the amount you allocate to stocks, bonds and cash, is the best way of meeting the financial challenges that accompany most retirements. Of course, you don’t have to do this alone – we can guide you in structuring a prudent investment strategy that can carry you through retirement.
Past performance may not be indicative of future results. Asset allocation does not guarantee a profit nor protect against losses. Investing involves risk, including the possible loss of capital. International investing involves additional risks such as currency fluctuations, differing financial accounting standards, and possible political and economic instability. These risks are greater in emerging markets.
Material prepared by Raymond James for use by its advisors