Whether or not you agree with the politics of former President George H.W. Bush, you have to admire the guy’s guts in old age. In June, to celebrate his 90th birthday, he parachuted from an airplane.
Bush’s plunge is a metaphor for some new thinking about investing in retirement. We’re told to reduce risk as we age, moving toward bonds and away from stocks. But new research shows that starting with a relatively small percentage of equities in retirement, and adding more as you age, may paradoxically make you more secure.
The new view builds on a system that a number of financial planners already use with clients, in which they separate retirement money into three categories, or “buckets,” representing different investment time horizons and accompanying risk.
In the first bucket you keep enough to cover a year’s worth of expenses in cash or money-market funds. That’s the secure, pay-the-bills money. In your second bucket you have short- and medium-term bond investments. You use that money to replenish the first bucket. The third bucket holds individual stocks and equity mutual funds. It’s the most risky portion of your holdings but also provides the most potential for growth.
Traditionally, planners have recommended rebalancing regularly so that the second bucket—the bond portion—becomes larger over time and your exposure to risk declines. That’s to preserve what’s needed in old age for big expenses such as nursing care.
But it’s in those early years that you need to be most protective of your principal, says Michael Kitces, a partner and director of research at Pinnacle Advisory Group in Columbia, Md. “When you first retire, your principal is the biggest,” he said. “It’s going to hurt a lot if something bad happens.”
In a 2013 study, Kitces and Wade D. Pfau, a professor of retirement income at The American College of Financial Services in Bryn Mawr, Pa., crunched the numbers related to bond- and stock-market behavior and found that by reversing the traditional retirement-investment strategy and gradually shifting a retiree’s portfolio, over 30 years, from 30 percent in stocks to 60 percent, a retiree could modestly reduce the likelihood of running out of money. “In essence, you’re simply gliding back to what you might have held in stocks at the beginning of retirement,” Kitces said.
Read Consumer Reports Investing Center advice to make investment products such as mutual funds, ETFs, and annuities work together for you.
Kitces and Pfau showed that the gains from that shift to stocks would more than make up for any big stock-market swing late in life. (The researchers tested multiple scenarios—including stocks and bonds performing at historical levels and at lower levels—and assumed that retiree withdrawals were 4 percent of savings in the first year, increasing annually with inflation.)
The gradual rebalance into stocks takes advantage of dollar-cost averaging, the keystone of preretirement investing. Presuming you spend a fixed dollar amount on stock purchases, when prices are low you get more shares; when prices rise you get less. Overall, you pay less per share than if you tried to time the market.
True, as interest rates rise, bond holdings will lose value, Kitces acknowledges. But if interest rates go up, bonds usually lose 5 to 10 percent, while the potential for loss is much greater when stock holdings tank. And historically, bond-market plunges recover more quickly than do stock-market dips. “You give up upside most of the time to reduce your downside in a couple of situations,” Kitces said.
Kitces outlines two ways to implement the strategy: You could actively rebalance one percent of your money into stocks every year from bonds or just leave the stock bucket alone and spend from the bond bucket. In the latter scenario, the bond bucket would naturally shrink over time.
To be sure, a lot of new retirees—especially those who suffered losses in 2000 and 2009—will embrace the idea of protecting their money early in retirement. But how will they feel about strapping on a parachute for the second, more seemingly risky part: starting with less in stocks and adding more?
Kitces says some of his clients are interested in the strategy; others are struggling with the concept. The approach may be best, he says, for a certain kind of retiree.
“What are you more concerned about: maximizing wealth or minimizing the downside?” Kitces said. “If your primary concern is that you don’t run out of money, this is a better risk-managed approach.”
—Tobie Stanger (@TobieStanger on Twitter)
This article appeared in the November 2014 issue of Consumer Reports Money Adviser.
Consumer Reports has no relationship with any advertisers on this website. Copyright © 2006-2014 Consumers Union of U.S.