Invest conservatively in retirement, right? Not so fast

The conventional wisdom is that retirees should invest conservatively to protect their savings. In fact, a commonly cited rule of thumb is that you should subtract your age from 100, and have that percentage of your savings invested in stocks. For example, if you’re 70 years old, you should have 30 percent in stocks and 70 percent in bonds, CDs, and savings accounts. And the percentage in stocks should decrease steadily as you get deeper into retirement.

Increasingly, financial advisors and researchers are questioning this strategy. Particularly in the current low interest rate environment, the interest you get from corporate bonds and CDs is unlikely to be enough to sustain your lifestyle. If you dip into principal to make up the difference, that raises the chance that you’ll run out of money. For example, if you withdraw 4% annually from your retirement savings starting at age 60, and your savings don’t grow significantly, your savings will be depleted after 25 years, when you’re in your eighties.

That’s why some advisors recommend keeping a larger percentage in stocks, in order to ensure your savings account will continue to grow while you draw it down. In his book You Can Retire Sooner Than You Think, award-winning financial consultant Wes Moss suggests keeping as much as 50% of savings in growth-oriented investments like dividend-paying stocks.

Yes, stocks are risky in the short term. That’s why advisors suggest limiting your exposure to equities as you approach retirement and in the first few years of retirement. A sharp market downturn and corresponding drop in your savings can significantly derail your retirement plans.

In a paper published in the Journal of Financial Planning, Wade Pfau, professor of retirement income at The American College of Financial Services, and Michael Kitces, partner and director of research at the Pinnacle Advisory Group, assert that investors planning for retirement should follow a U-shaped path: invest aggressively early in your career, emphasize conservative investments shortly after you retire, but then turn aggressive again later in retirement.

Although counterintuitive, the research showed that this strategy had the best chance of ensuring that an individual would have enough savings to last throughout retirement.

The authors examined 10,000 simulated scenarios and found that if a person kept a large exposure (60%) to stocks throughout retirement, or tapered down from 60% to 30%, they risked running out of money after 28 years. In contrast, by increasing their investment in equities in later decades of retirement, the individual had a much better chance of getting higher returns needed to maintain their lifestyle.

The authors wrote, “We find, surprisingly, that rising equity glidepaths in retirement – where the portfolio starts out conservative and becomes more aggressive through the retirement time horizon – have the potential to actually reduce both the probability of failure and the magnitude of failure for client portfolios.”

The best scenario is one in which the market is rising steadily at the beginning of retirement, and the person has a large exposure to stocks at that time. The returns early in retirement are crucial to making sure your savings will last. “Market performance in the first 10 years of retirement predicts 80% of final outcomes,” according to Pfau.

But no one can predict what the market will do within a timeframe of a few years. To hedge your bets, the authors suggest a small (20% to 30%) exposure to stocks at retirement, with the rest in bonds. In this way you have some exposure to stocks if the market goes up, but are protected from a significant market decline. Later in retirement, they suggest gradually increasing your percentage in stocks to 50% or even 70%, depending on your risk tolerance.

Pfau said this strategy gives you a “Heads, you win; tails, you don’t lose” scenario. If the stock market is rising at the start of retirement, you don’t do as well as with the conventional strategy. But if the market declines early in your retirement, you are more protected from major downturns that can impact your lifestyle down the road.

For more information

To read Pfau and Kitces’s paper, see this link.

For Kitces’s discussion of the paper, see this article.

The paper has stirred debate in financial research circles. To view what some other financial researchers have said and the authors’ responses, see this article.