“Will my money last?” That’s the biggest concern for most retirees. What can you do to stretch your retirement dollars for as long as possible? A recent article in the Journal of Financial Planning (JFP) analyzed six factors and the role each played in portfolio longevity. (Determinants of Retirement Portfolio Sustainability and Their Relative Impacts, by Jack C. DeJong Jr., Ph.D., CFA; and John H. Robinson). Let’s take a look at each:
Initial withdrawal rate
The less money you take from your portfolio each year, the longer it will last. No surprise there. What is somewhat unexpected, however, is that the withdrawal rate that is considered “safe” is shrinking. Thanks to lower assumed bond rates, the long held 4% rule should probably be renamed the 3% rule for those who need their portfolio to last 30 years. That’s one conclusion reached by the JFP article and it is backed up by other studies from respected researchers like Michael Kitces and Wade Pfau. So if you anticipate a long retirement, and you think bond rates will stay near their historic lows, it’s probably a good idea to dial back your initial withdrawal rate. If, however, you saved more than needed, retire later or have health issues that shorten your retirement (e.g. 20 years instead of 30) the 4% rule will likely hold.
The Fed’s decade long experiment with low interest rates has been great for borrowers, but terrible for retirees. Generating income is harder than ever. When the initial research was done for the 4% rule, mean bond rates were around 5-6%. Now they are much lower. Lower returns mean your portfolio won’t last as long. It looks like rates will stay low for the foreseeable future. Plan accordingly.
Retirees typically invest in both stocks and bonds so they can balance out the need for growth with the need for stability. What’s the right mix? Several recent studies seem to suggest that dialing up stock exposure a bit (say from 60/40 to 70/30) might help improve portfolio longevity. Before taking that advice, however, I think there are three important considerations. First, what is the likely future return of stocks? The studies assume a lower return for bonds, but assume future stock returns will be similar to past stock returns. When stocks are as richly valued as they are now, however, future returns are generally lackluster. Second, how will you respond in the face of increased volatility? The studies assume that retirees will calmly ride out any increased volatility from the higher stock allocation. That flies in the face of what we know from both behavioral finance studies as well as the long running Dalbar study on investor behavior. Volatility often causes people to do the wrong thing at the wrong time. Third, how much return do you need? If you haven’t saved enough, it can be tempting to swing for the fences and heavily overweight stocks. If you nest egg is adequate, however, it might make more sense to swing for singles and doubles rather than risk striking out. The takeaway from all this? Don’t take the added risk unless necessary. And if you decide to increase your stock allocation, wait for a good opportunity, such as after a market correction. Stocks will be cheaper and bonds will likely have rallied.
Inflation mutes your investment returns and diminishes your purchasing power. For retirees, low inflation is better and will help portfolios last longer. You can’t control the inflation rate, but it’s helpful to know what it is. We’re currently in a prolonged period of low inflation around 1-2%. That can help improve portfolio longevity and offset the lower expected returns discussed earlier.
Investment expenses act as a headwind against returns, so it’s important to a) keep them as low as possible and b) make sure the people you hire are adding value. In a large study on the value of advisors, Vanguard concluded: “Left alone, investors often make choices that impair their returns and jeopardize their ability to fund their long-term objectives.” This type of behavior often leads to “wealth destruction rather than creation.” Vanguard suggests that advisors can help add value if they “act as wealth managers and behavioral coaches, providing discipline and experience to investors who need it.” Specifically, they say to look for an advisor who can help with things like asset allocation, security selection, behavioral coaching and distribution strategies. According to Vanguard, those things are worth about 3% per year in net returns. In other words, a good adviser creates value, but has reasonable fees. The JFP article found that portfolio longevity is greatly improved when expenses are limited to around 1%, but diminish significantly when expenses rise beyond 2 or 3%.
Distribution strategies come in lots of different flavors, but the goal is usually the same: turn your assets into an income. The JFP article tested 4 different withdrawal strategies: a) spend stocks first, b) constant allocation, c) simple guardrail and d) spend bonds first. Most of those are self-explanatory except the guardrail strategy. With that strategy, withdrawals are taken proportionally from stocks and bonds with one exception. No withdrawals are made from stocks following a down year. Most retirees use the constant allocation strategy (draw from asset classes proportionally and rebalance each year), but the study found that the two strategies with the highest success rate were spend bonds first and the guardrail. Both strategies reduce the likelihood that you’ll have to sell assets for a loss during the early years of retirement which, not surprisingly, will help your money last longer.