Which way to invest once you retire?
— -- On the day you retire, have a party. Play some golf. Embark on a world tour. Just don't move all your retirement assets into bonds.
Traditional financial planning suggests that you should be almost entirely in bonds and other safe, income-producing investments by the time you retire. But that could be a big mistake. Your retirement could last 30 years or more — and if it does, you'll need stocks in your portfolio. In fact, you may be surprised to hear that some financial analysts think your retirement portfolio should probably look a lot like your pre-retirement portfolio.
Many years ago, retirees at TIAA-CREF, the teachers' retirement and annuity company, had the option of reallocating their retirement assets just once in their lifetime — from stocks to bonds.
Back then, the idea was that you would live off of the income from your bonds, preferably without touching the principal. Bonds are long-term interest-paying IOUs issued by the government, corporations and municipal organizations. Bonds even had little coupons that you could cut out and mail to the issuer, who would then send you your interest payment.
But living off your interest is more difficult these days. Here's why:
• Many people used their savings as a supplement to their retirement money, not as their main source of income. No longer. Just 16.9% of all retirees get corporate pensions now; the median annual pension payout is $7,692, according to the Congressional Research Service. (Median means half are higher, half lower.) And it's nearly impossible to live on Social Security alone; the average monthly Social Security payment is $963.
• Interest rates are low. A 10-year Treasury note yields 4.28% now. To get $5,000 a month from T-notes today, you'd need to start with $1.4 million.
• Inflation is a danger. Even modest inflation erodes the value of your income. Say you earn $5,000 a month on your retirement savings. And suppose the inflation rate is 3% a year. After 10 years, your $5,000 will have the buying power of $3,801 — a 24% decline.
"Fixed income won't keep up with inflation," says Mark Bass, a financial planner in Lubbock, Texas. "When people put too much in bonds, they wind up doing the exact thing they're trying to avoid — losing money."
• Life spans are growing. The average 65-year-old woman can expect to live to nearly 87, and the average 65-year-old man to 84, according to the American Academy of Actuaries. About 58% of couples age 65 will have at least one partner live to 90, and 28% will have one partner live to 95. And these are merely averages; half of all people will live longer than average.
If you want to beat inflation and make your money last as long as you do, you're going to need stocks in your portfolio — possibly quite a bit of stocks.
"Bonds won't do it," says Christine Fahlund, senior financial planner at T. Rowe Price trow.
Assume, for example, that you invested $1 million in bonds in 1977. You then withdrew 6% of your account the first year and raised that amount each year by the percentage gain in the government's consumer price index. Your account would have been emptied by 1998, 21 years later. Had you invested in short-term Treasury bills, you would have gone broke in the same amount of time.
An account invested entirely in stocks, though, would have grown to about $12 million in 30 years, even with withdrawals. Still, an all-stock portfolio isn't a guarantee that your savings will outlast you. Had you retired in 1972, for example, you would have been broke by 1985, assuming the same scenario as above. High inflation and lousy stock returns would have clobbered your retirement portfolio.
To make sure your money lasts as long as you do, you need:
• The right mix of investments. The biggest enemy of your retirement savings is a big drop in your holdings, particularly at the start of your retirement. Withdrawals magnify your account's drop. And they reduce any subsequent gains.
T. Rowe Price tested a variety of portfolio mixes to see how they fared when taking withdrawals. The mix with the greatest success was about 50% stocks and 50% bonds, Fahlund says.
"If you retire at 65, you have to think about keeping at least half your portfolio in stocks," she says.
But don't get too aggressive in your stock holdings. Loading up on small-company stocks or other volatile holdings can reduce the likelihood that your savings will last as long as you need it to. "Your chance of success goes way down," Fahlund says.
• The right withdrawal rate. If you need to increase your withdrawals for inflation, your first year's withdrawal should amount to 4% to 5% of your account, assuming you want the money to last 30 years.
If that seems like too little, you can try any of several alternative strategies that will allow you to withdraw more. You might, for example, consider freezing — or even reducing — your withdrawal rate if your account is down for the year. You might also consider capping any annual inflation adjustments at 4% or so.
The most deadly combination is a high withdrawal rate and a low percentage of stocks in your portfolio. The T. Rowe Price study looked at a portfolio of 80% bonds and 20% stocks. Assuming an initial 7% withdrawal rate, the portfolio almost never lasted 30 years. But a mix of 40% stocks and 60% bonds and an initial 4% withdrawal rate had money remaining at the end of 30 years 89% of the time.
Most retirees become more cautious about investing. And there's some sense to that: If you lose 50% of your portfolio after you retire, you won't have employment income to replace your losses. But playing it too safe can hurt you in the long run, too.