How Much Equity Should Investors Hold When Nearing Retirement?
One question that I am frequently asked is, “How much equity should I hold as I get closer to retirement?” While there is no foolproof allocation, it is worthwhile to explore two prevailing strategies.
Conventional wisdom has dictated that as an investor gets older, exposure to equities should be reduced. One oft-cited rule of thumb states investors should hold a percentage of equities equal to 100 minus their age. For example, if an investor is 80 years old, she should have 20% of her portfolio allocated to equities and the other 80% would be allocated to cash and bonds.
The primary reason for the reduction in equities is risk mitigation. Stock markets can be extremely volatile. Anyone who went through the dot com bubble in the early 2000s and the housing crisis in the late 20-oughts knows how quickly stock market wealth can evaporate. 2020 served as a painful reminder when March went into the record books as one of the worst performing months for US equities on record. (Although the government’s willingness to put over $2T worth of spending on the credit card caused the upward spike that equity investors in early 2021 are still enjoying. Deficits be damned!) Young investors can weather these times, because they may have up to 30+ years to recover from serious market disruptions. Unfortunately, retirees and those approaching retirement do not have that luxury.
Historically, bonds have been less volatile than equities. However, as prevailing interest rates have plummeted to all-time lows, it is becoming extremely difficult to get meaningful returns from a fixed-income portfolio. In the current environment, as bonds mature and new bonds are purchased, investors are becoming all too familiar with reinvestment risk. (Reinvestment risk is when an investor will be unable to reinvest proceeds of a maturing bond at a rate comparable to the return of that bond.) As an example, if you were earning 4% on a maturing bond, a similar bond today may only pay 1%. This is a meaningful difference from both a total return and cashflow perspective. And if an investor has allocated 80% of their portfolio to bonds, the issue can quickly compound. This trend may make followers of the old rule of thumb very nervous.
An alternative is something called the bucket strategy. Using this strategy, an investor divides her assets into 3 buckets: cash, fixed income, and equity investments. Rather than having a somewhat arbitrary allocation to each (like the age-based example noted above), an investor will use her projected annual cashflow need to determine the amounts to be held in the cash and fixed income buckets. By default, the equity bucket will hold the rest.
The amount of cash and fixed income, respectively, held in the first two buckets is calculated using two factors: the investor’s projected annual cashflow need in retirement (in additional to pension, social security or other retirement income) and an amount of time. The amount of time for the first bucket is number of years the investor feels comfortable with living on cash alone without selling any of the fixed income or equity assets. This bucket is like an emergency fund on steroids.
The second bucket would be the projected annual cashflow need in retirement multiplied by the number of years it would take for equities to recover during a bear market. Investors can look at history to help determine the number of the latter. First, the tech wreck. On March 20, 2000, the S&P closed at 1,527. It did not reach that level again until July 2007, taking a little over 7 years. During the mortgage crisis, the S&P 500 closed at 1,562 on October 8, 2007. It did not reach that level again until April of 2013, taking about 6.5 years. Since then, any downturn in the market has recovered within a year, including the 2020 COVID-19 dip that recovered in about 6 months.
Being somewhat conservative, an investor may feel that a total of 10 years of projected annual cashflow need in retirement held in cash and fixed income, 2 and 8 years respectively, may be sufficient to allow for a bear market in equities to recover. Depending upon the investors net worth, this may result in a greater or lesser allocation to equities than the age-based rule of thumb. This could have a significant impact on the amount the investor’s heirs will receive.
Even if the bucket strategy is selected, there are other facets to consider. There is much discussion about what kind of assets should go into each bucket, and the duration each bucket should consider. So even if this strategy is selected, there could be differences between how investors and financial advisors structure their own allocations.
Then there are the “what ifs?” What if an investor grossly underestimates the projected annual cashflow need in retirement? What if bonds take an unexpected hit in value? What if a bear market lasts 20 years instead of 10? What if an investor cannot stomach the bear market, and sells the equities at severely depressed values? Any of these events could have a negative impact on an investor’s retirement. So, if you use a bucket strategy, do so with great care.
Everyone’s circumstance is different, and asset allocation in or near retirement is by no means a one size fits all solution. Some investors look to real estate or private lending to help increase their cashflow. Others have taken on increased equity risk to make up for the lack of performance of bonds. We are in unprecedented times. Select an asset allocation that works for you and your situation. If you are unsure, seek help from a professional.
About the author:
JP Geisbauer is a Certified Public Accountant and a Certified Financial Planner ®. He is the founder of Centerpoint Financial Management, LLC, a retirement planning, investment management, and tax planning firm located in Irvine, CA. If you have specific questions regarding your situation, please schedule a complimentary 30-minute call here.
Disclaimer:
This article is for general information and educational purposes only. Nothing contained in this article constitutes financial, investment, tax, or legal advice. Before taking any action on any topic discussed in this article, please consult with your financial planner, investment advisor, tax professional, and/or attorney for advice on your specific situation.