The counterintuitive trick that could make or break your retirement
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Saving for retirement is hard enough.
But once you retire, a possibly even more difficult question presents itself: What can you do to keep yourself from depleting your reserve during your lifetime?
The conventional wisdom has it that, in order not to run out of money, you accumulate as much as you can during your working years, and as you approach retirement and during retirement, you invest ever more conservatively to protect your nest egg.
But a new study to be published in a forthcoming issue of the Journal of Financial Planning by Wade Pfau, a professor of retirement income at The American College of Financial Services, and Michael Kitces, partner and director of research at the Pinnacle Advisory Group, says this is approach is actually the opposite of what you should do.
While it is smart to invest more conservatively as you approach retirement age, Pfau says their research indicates that during retirement, it is better to gradually increase your investment in riskier equities like stocks and decrease your conservative holdings such as bonds.
He and Kitces write, “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.” They say over the course of a lifetime, this would mean the stock holdings in one’s portfolio would follow a U shape, with the lowest point correlating with the transition to retirement, and the highest points with the earliest and latest years.
Pfau presented their findings at the 12th conference for Bogleheads, a group of investors who follow the low-cost, long-term index-fund investing philosophy of Vanguard Group founder Jack Bogle.
“The paper is very credible, though counterintuitive, and very important. And Wade is by far one of the most credible academics in the field today,” says Harold Evensky, president of Evensky & Katz Wealth Management.
Heads, You Win; Tails, You Don’t Lose
It seems counterintuitive that during your decades of not earning any money, you would gradually “gamble” more of your hard-earned money in stocks over the course of your retirement.
But this seemingly wrong strategy works better than the conventional wisdom for two reasons. First, your nest egg is largest at the beginning of retirement, so that is when you stand to lose the most. As you draw down your savings, even if you increase the percent of your portfolio in stocks, the dollar amount at risk is either the same or less.
The second reason is a bit more complicated and requires us to step back for a moment. The two biggest question marks when it comes to spending retirement savings are how long you’ll live in retirement and how the market will perform during that period, neither of which are under your control. The only other factors that will determine whether or not your savings will last are how much you spend annually and how you invest your nest egg, both of which are under your control. However, no one wants to count pennies during their final years, so most people prefer to spend as much as they can every year without draining their accounts too quickly. But this balancing act requires that one’s investments do as well as possible.
Which takes us back to that out-of-your-control factor—market performance. “The worst-case scenario for retirement is that the entire 30-year retirement has bad market returns,” says Pfau, “but the worst case in history is that you retire when the market is down.” People who retired during a down market had a tougher time making their nest eggs last than those who saw the market, and therefore their portfolio, grow in the first years of their retirement.
“Market performance in the first 10 years of retirement predicts 80 percent of final outcomes,” Pfau says.