If you are nearing retirement, or are already retired, chances are pretty good that you are keeping a close eye on your portfolio. Retirement is a time to relax and enjoy the benefits of your years of hard work. In order to do so, however, you have to keep your retirement portfolio healthy. This is particularly true if you don’t have additional revenue streams, such as real-estate that can bolster your retirement income. A central question that many retirees have is whether they should continue investing after retirement. The answer to this question isn’t as easy or as intuitive as some may think.
The issue of whether to invest after retirement is contentious. Some consider any significant investing after retirement to be unwise. Others are more sanguine about investing after retirement and consider some degree of investment to be a necessary component of any comprehensive financial plan. We’ll weigh the arguments of both of these camps. To be sure, a certain degree of assets allocated conservatively is important. The logic behind moving your retirement plan assets into more conservative investment options once you approach retirement is so that market volatility won’t affect your portfolio as much. However, there are some downsides to this approach as well, which we will discuss in detail.
Ultimately, we’ll argue that investing after retirement can not only be beneficial but is often essential to maintain the health of your estate for a longer period of time. Investing after retirement can offer a means to grow your estate and consequently improve your lifestyle during retirement, but this comes with some qualifications. Just as investment strategies are important, so too is ensuring that you have a sufficient level of assets allocated conservatively. Finding the right balance comes down to working with a financial advisor that understands your financial situation and can help you achieve your financial goals in retirement.
Camp 1: Shift to Conservative Investments in Retirement
The first argument we’ll start with is very common. If you’re doing research on mistakes that people frequently make when they enter retirement, you’ll be told that one of them is failing to move your assets from equities to more conservative bonds. You probably already have a firm understanding of this asset allocation argument, but if you don’t we’ll go over why it sounds reasonable even if it’s ultimately incorrect.
The basis for the argument is the fact that the stock market is inherently volatile. This volatility makes it more profitable, but that profitability is associated with increased risk. Now, consider the changes that go into effect once you enter retirement. You’ll move from having a reliable salary and a growing retirement portfolio to having whatever you can safely withdraw money from your portfolio. Most people will have additional income coming in from social security, and if they have planned well they may have additional revenue streams like real-estate. For the most part, however, your retirement portfolio will serve as the foundation of your income for expenses throughout retirement.
This probably isn’t news to you, given the fact that you have been building your retirement portfolio for decades. The larger your retirement portfolio, the higher your income will be. Given that, it makes logical sense that you would want to do what you could to protect your portfolio. After all, it has to support you for the rest of your life. Allocating your assets in conservative investments shelters them from market volatility, which on the surface seems to be the perfect solution to the problem. However, consider a couple of things. This argument makes sense assuming that your retirement portfolio is sufficiently large to support you over two or even three decades. You will also have to think about your withdrawal rate and the health of your retirement portfolio. If you are accustomed to the lifestyle a 5% withdrawal rate provides you, is your portfolio going to be sufficient to support that withdrawal rate over 20 or even 30 years? You will also have to adjust your withdrawal rates for inflation, which can highlight some of the flaws in this approach.
Camp 2: Investing After Retirement is Essential
The second approach is to choose to allow some of your assets to remain in stocks after you retire. This may not align with the conventional wisdom, but it does have strong data to back it up. Let’s take a look at the contours of this argument in greater detail. At a basic level, the belief is that continuing to keep a portion of your assets allocated in stocks allows you to continue to grow your retirement portfolio while you are in retirement. This allows you to maintain a higher quality of life by allowing you to withdraw from your portfolio at a higher rate over a longer period of time. Put another way, the same reason you would keep your portfolio allocated into stocks before retirement is the reason you would leave assets allocated in stocks after retirement.
You might be wondering how this approach addresses the very obvious issue of risk. Risk is one of the key reasons so many people believe that assets should be allocated conservatively during retirement. Risk of loss is very real, and when you are in retirement, watching your portfolio shrink due to market volatility can be extremely difficult. The next market downturn could be right around the corner, and if the majority of your assets are allocated into stocks you could experience significant losses. So, given this, why would anyone consider keeping their assets allocated into equities?
The answer is that it makes sense to keep some of your assets allocated into stocks because over longer periods of time this will allow your portfolio to continue growing. We’ve already established that the market is inherently volatile. This volatility may result in short-term losses. Those short-term losses may last weeks, months, or even years. However, over longer periods of time the overall health of the market will prevail and your returns will stabilize. Put another way, the length of time that you leave your retirement portfolio assets allocated in stocks minimizes the risk that short-term market volatility poses them. This is, at its core, the same reason that the majority of people invest their retirement portfolio in stocks while they are still working. The idea is that your portfolio will grow over time despite short-term losses, provided that your assets remain invested for a sufficient period of time.
Both Approaches Head to Head
One of the best ways to see the difference between these two investing strategies is to visualize it with a withdrawal rate analysis. A withdrawal rate analysis simply assesses the viability of your retirement portfolio based on different withdrawal rates and different time horizons. A withdrawal rate analysis places a probability on the success of your retirement portfolio using historical market data from the Standard and Poor’s 500 and corporate market bonds to calculate returns.
In our example, one portfolio has an allocation of 75% stocks and 25% bonds, and a second portfolio has an allocation of 75% bonds and 25% stocks. These two allocations correlate to the two arguments that we went over previously. An individual who had shifted their assets to more conservative investments in retirement would obviously have a portfolio that has a greater portion of bonds, while an individual who had continued investing after retirement would have a portfolio with a greater portion of stocks.
A comparison between these two allocation profiles yields results that are perhaps surprising. Let’s start with a 4% withdrawal rate, which many people consider safe. A portfolio that is heavily invested in bonds will have a 100% rate of success out to 20 years, but then the success rate begins to dip. At 25 years there is only a 95% success rate, and at 30 years there is only an 80% success rate. In contrast, a portfolio that remains heavily invested in stocks after retirement will have a 100% success rate all the way to 30 years if your withdrawal rate is 4%.
At higher withdrawal rates, the flaw in keeping your portfolio primarily in conservative investments becomes abundantly clear. While you would be able to maintain a 99% chance of success with a 6% withdrawal rate over 15 years, after that point your success rate drops off precipitously. By 20 years you only have a 52% chance of success, and by 30 years your success rate is a paltry 22%. In contrast, a portfolio that remained invested in stocks would fair much better. 20 years in you would still have an 80% success rate, and at 30 years your success rate would still be 60%.
What we can clearly see from the withdrawal rate analysis is that using historical market data, portfolios that have a higher allocation of stocks remain stronger over longer periods of time. While you probably wouldn’t want to use a 6% withdrawal rate either way if you were expecting to be living off of your portfolio for 30 years, the comparison between these two approaches demonstrates that even at higher withdrawal rates portfolios that remain predominantly invested in stocks fair much better. What is important to note is that these are long-term trends, using long-term data. So, how do you address the very real risk that short-term market fluctuations can pose? The answer is that you invest a portion of your portfolio in conservative investments.
Riding Out the Volatility
The truth is, your investing after retirement must be a balance of both equities and bonds. You’ll need both to give yourself the best chance for security in the short- and long-term. You’ll need equities to continue growing your portfolio over the long-term. At the same time, you’ll need some portion of your portfolio invested in conservative investments so that you can weather out market volatility.
Figuring out how much of your portfolio to invest conservatively is a question you will have to work closely with your financial advisor to answer. Each situation is unique, and maximizing your growth will require working with someone that understands your financial needs. All that being said, let’s turn to some more market data to figure out how much you need set aside in conservative investments. We use historical data for the Standard and Poor’s 500 index, which provides a useful benchmark for gauging market performance. From this data, we can see that over a 5 year period an investment would have an 80% chance of having a positive return. Over 10 years this becomes an 89% chance. Over 20 years this chance becomes 100%. Given this, it makes the most sense to set aside at least a minimum of 5 years of withdrawals. In other words, setting aside 5 years worth of withdrawals will give you an 80% chance that your investments in equities will have turned around.
Now, remember that this recommendation is a minimum. Some people may have a higher or lower tolerance for risk. In the end, how you allocate your investments will be up to you with advice from your financial advisor. It’s always important to have a full understanding of the risks that each approach carries and to make your decision according to what is best for your needs. As should be clear from the data, you’ll want to maintain at least a portion of your portfolio invested into stocks. This will allow your portfolio, and your estate, to stay healthier over a longer period of time. With this approach, you may also be able to increase your withdrawal rate while still having a healthier portfolio.
As with any financial decisions, it’s incredibly important to work with your financial advisor while crafting an investing after retirement strategy. Deciding to start investing after retiring can be a boon for many people, but it should always be done with a full understanding of the risks associated with it. If you are interested in learning more about the benefits associated with investing after retiring, please contact Bull Oak Capital today to schedule a free consultation.