Retirement

What is the ideal retirement portfolio allocation in the retirement years? This is something I never really had to contemplate before, but now I must make sure my portfolio lasts until I moved on to the great beyond. 

Making My Portfolio Last

We are rapidly approaching the end of the accumulation phase of our portfolio and approaching the distribution phase. But the distribution phase brings on a whole different set of problems I never had to deal with before.

At this stage of the game, I have been through several crashes and bear markets. Intuitively, I understand that bear markets always come back over the long term, and I understand that I must invest in risk assets if I hope to beat inflation. But once that biweekly paycheck disappears, I become a bit nervous. 

The Ideal Retirement Allocation For a Risk-Averse Investor

As I approach retirement, I want my portfolio to accomplish the following;

  1. Minimize sequence of return risk
  2. Allow me to sleep at night
  3. Keep pace with inflation
  4. Leave a legacy to my children

The Perfect Allocation

What is that perfect allocation? Conventional wisdom tells you to subtract your age from 110; the number you get should be allocated to stocks.

An Example: If you are 30 years old, 80% should be allocated to stocks and 20% to bonds, (80/20). In my case, that would mean 45% of my portfolio should be allocated to stocks. I will not disclose my age. I will leave it up to the reader to figure out what my age is.

Suffice to say that 45% of stock allocation at my age seems a bit high for me, especially when there is no paycheck. In a market crash or bear market, a 45% stake in equities can still lead to sizable losses.

Initially, I thought a 40/60 split might do the trick but somehow, I still did not feel comfortable with that. That seemed rather high, too.

Never Touch Principal

My first thought was to never touch the principal of my portfolio. That is the ideal retirement when you never have to touch principal and you can live on the income your portfolio generates. 2% in today’s dollars is all I need to withdraw from my portfolio to give me the standard of living I want. Last year, with the 10-year treasury yielding above 3%, that seemed to be doable with virtually no risk.

Last year, the news was replete with articles of an overheated economy. The Fed was going to begin to raise rates, a complete reversal of its former policy of easy money. But things can change on a dime – and they did. 

On Oct 5, 2018, the ten-year treasury yield hit 3.34%.

Certain economic developments signaled a softening of the economy, the Fed turned dovish and reversed course again.

The ten-year treasury took a sharp turn downwards in only a few short months. The 10-year treasury yield now sits at 2.054% and this month, the Fed is expected to cut interest rates by at least 25 basis points. But looking at how things are, it seems more probable that they’ll use 50 basis points, which means the ten-year risk-free rate of return will be below 2%. 

Fed Chairman, Jerome Powell, highlighted the worrisome global economic outlook in his testimony and stated that rate cuts in July will take place. He also signaled that additional rate cuts were to be implemented, too.

It is very likely we will again enter a zero rate environment. 

Why Is The Ten-Year Treasury Yield So Important For Retirees?

The goal, as an investor as he enters retirement age, is to de-risk his portfolio. Usually, that’s done by eschewing risk assets and buying more bonds or instruments that carry less risk. 

The yield on the ten-year treasury represents the risk-free rate of return. If your goal was not to touch the principal of your portfolio, last year, your portfolio could have essentially been made up entirely of 10-year treasury bonds if you were able to live on the 3.34% of the income generated by the bonds.

At this point, your portfolio would have lasted into perpetuity, and you would be considered infinitely wealthy because your money will never run out.

If you needed $100,000 a year to live on and received $30,000 in pensions and/or Social Security, you are left with $70,000. For your money to last into perpetuity (risk-free and without touching principal), you need; 

For $70,000 annually Yield on 10 yr treasury
risk-free rate of return
Portfolio needed
to last into perpetuity 
Last Year 3.34% 2,095,808
This Year 2.054% 3,407,984

What a difference a year makes! The portfolio required, where you avoid touching the principal, has now increased by over a million dollars.

(note: for the above example, for simplicity, I am not including inflation)

So What Happens When Bond Yields Continue To Drop?

Unfortunately, this isn’t good news for investors approaching retirement.

It forces retirees to either draw from principal or increase their risk exposure. The size of your portfolio doesn’t matter – the concept is the same. 

As bond yields and interest rates decrease, retirees are forced to increase their exposure to risk assets. Risk assets have to carry the extra burden from the loss of income that risk-free assets no longer provide. 

In other words, the lower the interest rates drop, the truer this becomes.

So, What Is The Retiree To Do?

Following this, I determined how much I can withdraw from my portfolio (today’s dollars) until age 100 at 2% interest rates. I figured 70% of my portfolio would be sufficient.

In other words, 70% of my portfolio I would allocate to bonds and cash-like instruments. This was the amount in today’s dollars I needed to live on – no risk. The remainder 30% I would invest in risk assets. 

The risk assets (I thought) should have provided the protection I needed against inflation and sequence of return. So I looked at the following table:

Asset Mix Max Historical Annual Loss
30/70 split 12%
40/60 split 17%
50/50 split 22%
60/40 spit 27%
70/30 split 33%

In this phase of my life, I do not want to stomach more than a 10% loss, so I thought a 30/70 split was the appropriate target. But the nagging question was: Will that 30% be able to keep up with inflation and still give my children a sufficient legacy?

The Center of Gravity for Retirees

I came across an article by Rick Ferri, titled The Center Of Gravity For Retirees. Rick argues that the 30/70 allocation is the optimal allocation for Retirees (as opposed to the 60/40 allocation put forth by Peter Bernstein for Long Term Investors; individuals that are not yet in retirement.)

The most important element during the distribution phase of a retirement portfolio is the sustainability of income, not the growth of the portfolio like long term investors stress upon. A bad sequence of returns or high inflation can substantially decrease the life of a portfolio.

Rick points out that a 60/40 split would fall 27% during a 16 month period from November 2007 to February 2009. In other words, for example, a 100,000 portfolio would have fallen to $73,346. If you include withdrawals of 4%, your portfolio is now at $68,675, with a loss of 31%.

According to Jim Otar’s Retirement Income Planning course, The gain required to breakeven after a 30% loss is 42.9%. Historically, there is only a 63.6% chance to recover a loss of this magnitude after three years, which is the typical length of a cyclical trend. Peter contends that the center of gravity for retirees shifts from 60/40 to 30/70 where the focus changes from growth to preservation of principal and sustainability of income.

A 30/70 portfolio has less volatility with the least risk. On a 5-year rolling risk-adjusted period (1929-1932), the 30/70 portfolio lost money only once since 1929, while the 60/40 portfolio lost money five times. Retirees will like the lower volatility in down markets.

Sequence Of Return Risk

According to Wade Pfau, the most perilous times for sequence of return risk is the first ten years of retirement.

I decided to test the portfolio I needed with the risk-free rate of return of 2.054% in an even lower bond yield environment.

Using Otar’s retirement calculator, I entered a portfolio value of $3,407,984, the value needed for a portfolio with a risk-free yield of 2.054%. I began with an initial $70,000 withdrawal that I need for expenses.

Using a conservative 1.5% yield for bonds/cash, Otar’s retirement calculator said that in the worst-case scenario, I would run out of money at the age of 90, and in an unlucky scenario, I would run out of money at the age of 94, with 30% in stocks and 70% in bonds. (Assumptions 1.5% bond yield, historical calculations for both inflation and equities). 

Factors such as inflation and a slowing economy will affect yields on bonds differently. I realized that this might not be a completely accurate picture, but I wanted to see what the effect of a permanently low yield on bonds might be.

Beating inflation

As one’s human capital drops to zero, keeping volatility at bay and preserving the portfolio principal becomes the retiree’s primary focus. In the long term, stocks have kept pace with inflation, but there are long periods where stocks do not keep pace with inflation, so this can be a challenge. 

So I thought if I dollar cost average back into the market, I could minimize those first ten years of sequence return risk. I could also purchase equities at low valuations as I did when we received regular paychecks.

I began to explore the idea of a rising equity glide path. What will happen if I start with a low exposure of 30% in equities and 70% in bonds (30/70) and increased the equity percentage as I age?

At age 70, both my wife and I will be receiving social security and we will have a small pension. Therefore, we can afford to take on more risk when we hit 70. 

The major cons I see in the rising equity glide path is the discomfort you may have with an increasingly high exposure to equities as you age or if in the first ten years, there is a Bull market, you may miss out on some gains.

However, the fear of exposure to stocks should minimize as more guaranteed streams of income come in (at age 70), and signs are pointing to a recession. This current economic cycle of high growth and outsized market gains will eventually come to an end.

The Ideal Split

In a research paper authored by Michael Kitces and Wade Pfau, it was noted that a portfolio that begins and ends with a 60/40 (stocks/bonds) split with a 4% withdrawal rate ended with a 93.2% probability of success. On the other hand, a portfolio that begins with a 30/70 split and ends with a 70/30 split actually gave a higher probability of success at 95.1%. It also had lower volatility and a lower average equity exposure during retirement 

I then looked at the same 2.054% yield risk-free portfolio (without touching principal) using a rising equity glide path. I looked at the analysis I got from Otar’s optimizer and got a worst-case scenario of 2.8 million dollars and a best-case (lucky) case of 18 million dollars.

retirement
Rising Equity Glide Path

Takeaways

  • The risk-free rate has dropped substantially since last year.
  • As yields drop, the retiree is forced to take on more risk to preserve his income stream and keep pace with inflation.
  • The center of gravity for retirees is 30/60 (stocks/bonds) versus a (60/40) split for younger workers.
  • The first ten years of retirement are the most perilous years for retirees in terms of sequence of return.
  • A rising equity glide path may be the answer to maintaining a portfolio in today’s low-bond economic environment for the retiree.
  • History has shown that for a retiree, a 30/70 portfolio rising to a 70/30 portfolio has less volatility and risk than a portfolio that begins and ends with a 60/40 split.
retirement
Probability of Depletion

Conclusion

How must we look at the allocation of our portfolios in retirement?

We often hear that past performance is no guarantee of future performance. That is particularly true of today’s economic environment. 

Quantitative easing has pushed us into uncharted territory of low bond yields and high stock valuations. No one knows how this economic environment will end, but using history as our guide and stress-testing the results is the best reference we have. 

Therefore, it is imperative to closely monitor your portfolio to make sure it lasts through retirement since the burden now rests on the retiree for their own economic well being.

Other posts of interests

Morningstar or The Motley Fool

Six reasons why you should be concerned about the current bull market

How to beat the market

Three million dollars may not be enough to retire on

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