How much should you invest in the stock market when you retire?
That’s one of a series of critical decisions that older workers face as they transition out of the workforce and into retirement.
In a previous post, I outlined an overall framework for developing an effective retirement income portfolio. Such a portfolio includes lifetime “retirement paychecks” that protect against investment risk, and variable “retirement bonuses” that have the potential for growth but also carry investment risk.
One common source for generating retirement bonuses is to develop a systematic withdrawal plan (SWP) to deploy assets invested in IRAs, 401(k) plans, and other retirement assets. A best practice with a SWP is to periodically increase your withdrawals if you experience favorable returns but decrease your withdrawals if investment experience turns out to be poor. This helps protect you against sequence of returns risk, when you experience poor investment returns early in your retirement.
A key decision with any SWP is how to allocate your retirement savings between risky investments, such as stocks, and less risky assets, such as bonds and other fixed income investments. Too often, retirees and their advisers make this decision in isolation, meaning they only look at the potential risk and reward with the SWP without regard to considering other sources of retirement income.
A better way to make the asset allocation decision is to consider your total retirement income portfolio. To make smart choices, determine the percentage of your total retirement income that you’re comfortable subjecting to investment risk.
A recent report from the Stanford Center on Longevity (SCL) provides interesting insights that apply to many middle-income and upper-middle-income retirees. For these retirees, Social Security is projected to provide two-thirds to 80% or more of their total retirement income, particularly if they’ve optimized their Social Security benefits through a thoughtful delay strategy.
Social Security benefits provide protection against three key retirement risks:
- Longevity (living a long time is a risk!)
- Investment (stock market risk)
- Inflation (the risk that your retirement income loses purchasing power)
This result might justify a significant allocation to stocks for the portion of a retiree’s retirement income that’s generated from a SWP, since investment risk might apply just to a small part of their total retirement income portfolio. Of course, in this case, it’s important that retirees understand the potential future volatility in the amount of income that their SWP generates.
The graph below shows the breakdown for one affluent married couple between retirement paychecks (Social Security) and retirement bonuses (a SWP that uses the IRS required minimum distribution to determine the annual withdrawal). This graph analyzes five different scenarios for various retirement ages.
In this graph, the blue portion of the bars represent Social Security benefits, which are not subject to investment risk. The red portion of the bars represents the income that the SWP generates, which gives you a visual picture of the proportion of total income that’s subject to investment risk.
If you have any pension or annuity income, you’d add those amounts to the blue portion of the retirement income that’s protected from investment risk.
This type of information can help you decide how much investment risk you’re willing to take and the impact on your total retirement income portfolio. Even if you invest 100% of your retirement savings in stocks, it’s likely that less than half of your total retirement income will be subject to investment risk.
However, it’s also likely–and certainly understandable–that most retirees would be uncomfortable devoting 100% of their retirement assets to stocks. However, they might be comfortable with a typical target date fund that applies to retirees, which commonly has a 50% allocation to stocks, or a balanced fund that might devote one-third to two-thirds of assets in stocks. In the above example, if the retiree adopted an asset allocation of 50% to stocks, only about 20% of their total retirement income would be subject to stock market risk.
No matter which route you decide to take with your retirement portfolio, take the time to develop a thoughtful asset allocation for your retirement savings in retirement, so you don’t toss and turn at night when the stock market is gyrating.
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