What is the best investment strategy for retirement? There is a tried and tested answer to this question. The generally accepted wisdom is that you should hold the percentage of bonds in your portfolio that matches your age in years. So if you retire at 65 you would have 65% bonds and 35% stocks. If you started investing when you were 25 years of age you would start with 25% bonds and 75% stocks and then each year you would rebalance your portfolio moving 1% more into bonds.
Other accepted tenets are that your stock portfolio should mimic the market and your bond portfolio should cover a spread of riskier and low or no risk bonds.
The simplest and most efficient way to create a stock portfolio that mimics the market is to select low-cost ETFs that track market indexes. It is a good idea to have broad exposure to different levels of market capitalization. This is easily done by for example having one ETF that tracks the Standard and Poor’s 500 for large-cap exposure, one ETF that tracks the Standard and Poor’s 400 for mid-cap exposure, and one ETF that tracks the Russel 2000 to cover small-cap.
The idea is that the bonds deliver income in the form of coupons, some stocks deliver income in the form of dividends and the stocks in your portfolio should deliver capital appreciation so that your principal will not be eroded by inflation. There are variations on this model, including adding real estate to your portfolio which should also pay you income stemming from tenant rents.
The sacred principal
This approach to retirement financing creates this somewhat inaccurate and artificial division in our minds. We view money that flows into our account from dividends or bond coupons in a different light to the capital value of our investments.
Somehow the capital value or principal is upheld in our minds as sacrosanct and in need of preservation at all costs, while the income stream is the cash we are allowed to spend.
While this view is on one hand overly simplistic it also doesn’t really work in today’s economic conditions and market environment.
Interest rates at all-time lows
I hope everyone will have realized by now that interest rates of around 0.5% on savings accounts and not much more available from bond coupons is derisive. You can reasonably say that most economies of the world have been cut off at the knees by the impact of the pandemic and central banks have a legitimate task to do what they can to rescue us all.
For the retiree living off investments, it means you really have to know how to navigate these economic conditions to stay financially secure through retirement.
While interest rates are at all-time lows, inflation is still lurking in the shadows. It is easy to focus on the Consumer Price Index or CPI as the main indicator of inflation but that may miss the point.
If in your retirement you are just going to be buying the same basket of goods used for the CPI then you know what you are looking at. If you are interested in what the CPI did over the last few years, here’s what it looks like
What is interesting is the variability of inflation in the components of the CPI. For example at one end even though in 2020 the CPI was 1.4% some items like meat, fish, eggs, and dairy went up by 4.5%, and food at home in general increased by 3.9% while at the other end gasoline went down by more than 15%.
Higher risk bonds
While the old stalwart of treasury bonds or T-bills will pay above these derisively low rates depending on their term, lower grade and therefore higher risk bonds will pay more. Even with lower grade municipal bonds though, the yields only get up above 1% if you go for a 5-year term. Twenty-year municipal bonds current yields are still only 3.75%
Another approach to receiving an income stream is to purchase high dividend-paying stocks.
Since stocks pay dividends every quarter, a clever way to do this could be to hold one set of high dividend stocks that payout January, April, July, and October, then another set that pays out February, May, August, and November, and a third set that pays out March, June, September, and December.
Again though you will be hard-pressed to find stocks that payout dividends of more than about 3.5 to 4% and some pay annually or semi-annually or just whenever they choose to. What’s more, there is no obligation on a company’s board of directors to pay dividends. In an economic downturn or if the company just falls on hard times they can decide to cut or just eliminate dividends altogether.
Another approach to obtaining an income stream is from investments in real estate. With a large portfolio, general guidance says that it is reasonable to invest between 5% and 15% in real estate. However, I would note that investors who are experienced with and understand real estate are likely to hold a larger portion of their investments in this asset class.
Real estate has its own advantages and risks. The one potentially big advantage is that the returns on real estate tend not to be correlated with the stock market. So building investments in real estate could be a good way to diversify your portfolio.
Like other areas of investment, to do well in real estate investing you need to do your homework. You need to pick funds or projects that have a good chance of success.
Higher risk lower return
However, sticking with stocks and bonds if you adopt all the formulae above to a retirement portfolio in the current economic circumstances it will oblige you to look for high yield assets and you will actually be taking on more risk than is necessary.
In short, the classic approach to income yielding investments will not cut it in today’s economic environment.
The total portfolio approach accepts that stocks perform well some of the time and bonds perform well at other times. The other reality it faces is that interest rates and dividend payments are pitifully low and any over-reliance on these will likely result in very poor results and a low income during the all-important retirement years.
Instead of creating a portfolio of income yielding assets such as coupon paying bonds and dividend-paying stocks you create a portfolio that is balanced between the different asset classes of stocks and bonds, but the stocks provide appreciation to hedge against inflation while the bonds act as a store of value when stocks are under-performing.
You don’t go out of your way to find income-producing stocks or bonds. Instead with the total portfolio approach, you focus on total returns and reducing volatility and hence risk.
You make disbursements from your portfolio into cash by liquidating assets depending on what has performed well while rebalancing your portfolio. The general principle most advisors suggest is that you would draw down on the total value of your nest egg at a fixed rate of 4% a year.
As noted the bonds act as a store of capital for times when stocks haven’t done so well. If you invest in a market basket of stocks then the expected return will be around 10% a year. But that 10% will come with substantial volatility.
If we update the chart of annual returns of US stock markets as measured by the Standard and Poor’s 500 index to include 2020, this is what we get.
Obviously, all that volatility could play havoc with your retirement if you didn’t smooth out those returns.
Running some numbers
So much for theory. Let’s get real and run some numbers.
I will assume that a couple has built a $2 million nest egg over their years of earning, saving, and investing and that they are retiring in the year 2000 and will need their funds to last until 2020.
I propose to look at three different portfolios.
Portfolio 1 is composed of 40% bonds covering a range of grades and 60% comprising a basket of stocks that tracks the performance of the Standard and Poor’s 500 index.
Portfolio 2 takes a more risk-averse approach. It is composed of 50% of only the very safe government-guaranteed short-term (3-month) T-bills, the other 50% comprises a basket of stocks that tracks the Standard and Poor’s 500 index.
Portfolio 3 is more aggressive and consists of 10% bonds of lower grade and hence high risk and return 80% a basket of index tracking stocks like the other two portfolios, and 10% real estate.
For the basket of stocks that track the Standard and Poor’s 500 index, we will assume that all dividends are reinvested.
For the blended bond portfolio, we will take an equal mix of 3-month Treasury Bills, 10-year Treasury Bonds, and corporate bonds of BAA grade.
For the real estate portion, we will assume a portfolio of diversified REITs.
All of these investments are very liquid, so we would have no issues liquidating any of them and rebalancing the portfolio as needed.
To simplify this a little we will take the returns from the previous year and use that as our income for the current year. There is a certain logic to this. We can imagine that on 1 January we look back at the performance of the portfolio over the previous year, and liquidate whichever were the best performing assets in descending order until we have liquidated 4% and then rebalance the portfolio for the coming year.
I’m also going to run the simulations using two kinds of withdrawals, firstly fixed at 4% of the total value of the portfolio, then secondly starting in the first year at 4% of the portfolio value but then in subsequent years withdrawing that same amount in inflation-adjusted terms, so that your purchasing power stays constant through the years.
The chart below shows the annual returns of the components of our three portfolios and the annual rate of inflation from 1999 to 2019.
All calculations and simulations by https://badinvestmentsadvice.com/
Portfolio 1: 40% mix of bonds, 60% stocks
Before we can get down to business we have to calculate the return on our bond portfolio for each year. We said it would be an equal mix of 3-month T-bills, 10-year T-bonds, and corporate grade BAA. Tabulating that against the returns of our stocks would look like this.
So on 1 January 2000, we look at the performance of the components of our portfolio and before any withdrawals, we have $800,000 in bonds and $1,200,000 in stocks. Looking back at 1999 our stocks returned 20.89% while our bonds returned -0.92%, so not a good year for bonds.
According to the total portfolio approach, we would withdraw 4% of the $2 million, i.e. $80,000 in this case entirely from the stock part of the portfolio.
Actually, the only reason we would want to do that is to reduce any transition costs. If there are no trading costs, fees or commissions then it doesn’t matter where we take the withdrawals from since we will be rebalancing the portfolio at the same time. But even though most brokers don’t charge fees or commissions on stock or ETF trades, there will always be slippage so we want to minimize turnover to reduce that effect.
We would be left with $800,000 in bonds and $1,120,000 in stocks totalling $1,920,000. We would then rebalance our portfolio moving $32,000 from bonds into stocks to achieve the balance of 60% stocks and 40% bonds.
Essentially, at the beginning of each year, we would then rinse and repeat.
This is what that would look like starting at the beginning of the year 2000. Since in this scenario we withdraw the total sum for the year at the beginning of the year, I’m also showing that sum adjusted for inflation for the whole year.
That is the sort of thing that can happen when you retire.
There will just be times when the market suffers a down period and you have the bad luck to retire just when that happens The year 2000 was right before the dot com bubble burst. That ushered in three years of downward movement on the stock market. The next big nasty was triggered by the sub-prime crisis and the damage of the ensuing recession of 2008 and 2009.
Under this scenario, the annual withdrawals never made it back to the purchasing power of the first year of withdrawals after we factor inflation. As we can see there would be some fairly lean years if this was the sole source of income.
On the other hand, the portfolio still has a value of $2.8 million. That tells me that if they needed to continue making withdraws this system would not run out of money, probably not even for another twenty years.
Let’s see what happens with this scenario if we withdraw an amount that equals 4% of the initial total value and then an amount every year that would maintain the same purchasing power of the first year’s withdraws.
At least in this case our couple would not see an erosion of their purchasing power over the 20 year period. The total portfolio value is now $1.8 million. We don’t know what the returns from the different asset classes over the coming years would be but it is clear that the larger withdrawals, in nominal terms will eat into the portfolio value and at some point in the future the couple will run out of money.
Portfolio 2: 50% 3-month T-bills, 50% stocks
Now we will take a look at how the couple would do if they were much more risk-averse.
We adopt the same approach as in portfolio 1 above. In the first case let’s look at how their finances would look if they withdraw 4% of the total value of the portfolio every year. Again we make the withdrawal by liquidating some of the assets that have performed the best and then rebalance the portfolio to achieve the desired asset allocation.
This is what that would look like.
So, in this case, there would also be some very lean years and at the end of the 20 year period, the purchasing power of the annual withdrawals is just 67% of what it was at the beginning. That would hardly make for a very rewarding retirement. On the other hand with a portfolio value of $2 million after 20 years, the approach does look that it could be sustained for some years into the future.
As we can imagine the situation looks less sustainable if we make withdrawals every year with the same purchasing power. This is what that would look like with portfolio 2.
With a total portfolio value after 20 years of $0.9 million with this rate of withdrawals, the couple will likely run out of money in a few years depending on what the market does.
Portfolio 3: 10% low grade bonds, 10% real estate, 80% stocks
We are going to follow exactly the same approach for the other two portfolios. Firstly giving our retired couple 4% of the total portfolio value as an annual withdrawal and then rebalancing the portfolio. This is what that would look like.
In this case, there were more than a few lean years. In 2009 the purchasing power of the annual withdrawals was half that of the withdrawal in 2000.
On the plus side by 2020, the inflation-adjusted value of the annual withdrawals would exceed the value of the withdrawals in the year 2000 by a small margin. Also, the total value of the portfolio in 2020 was $3.2 million so they could probably continue indefinitely and leave a decent legacy at the end of it.
This is how portfolio 3 would have behaved if they had made withdrawals at the same inflation-adjusted value.
It looks like they would have survived. Though there are times when they would have been close to losing it all. In 2009 the total value of the portfolio dropped to $1.1 million. If there had been a few more bad years of low or even negative stock market returns then they would likely be in a hole they could never climb out of without adjusting their withdrawals.
Also with a total portfolio value of $1.9 million and ever-increasing nominal value of the annual withdrawals, this approach main not be sustainable indefinitely with any degree of comfort.
Looking at how the three portfolios have performed over the 20 year period, I would be tempted to try one more portfolio. How about a mix of assets that achieves less volatility of returns, while still maintaining enough exposure to the better-performing assets? This way we ensure that the portfolio grows and keeps pace with inflation.
Portfolio 4 consists of 33% stocks 33% low grade bonds 33% real estate. Again we will run a simulation, first making withdrawals of 4% of the total and then another simulation making withdrawals that are the same amount adjusted for inflation.
Portfolio 4: 33% stocks, 33% low grade bonds, 33% real estate
Here is what that would look like withdrawing a steady 4% of the total portfolio value
And this is what that looks like when we make withdrawals that maintain purchasing power.
Well, this has improved the situation considerably.
In the first instance when you are just withdrawing 4% of the total value each year, you still experience some down years but the drop in purchasing power, in 2009 for example isn’t as significant as the drop experienced for the other portfolios.
What’s more, with the withdrawals maintained at constant purchasing power, the total portfolio value is over $4.6 million after 20 years. In all probability we would have decided to live it up a little and start withdrawing more, maybe just adopted the 4% rule.
Something else this is a testament to is the value of adding real estate to a portfolio as another source of returns that are not closely correlated with the stock market.
Improving the odds
A legitimate question could be, how else could you improve your odds of better returns on a retirement portfolio? I would answer that question with two suggestions.
The first is to pay attention to the sectors that are outperforming other sectors and the market. This article explains how investing in sectors rather than just the whole market can improve the performance of a portfolio of stocks.
Another way to improve performance and importantly reduce the variance of returns is to pay attention to style factors. This article explains how to build style factors into your investing approach.
In the case of our retiring couple, there could be good reasons why they would want to maintain their purchasing power year on year. Alternatively, there could equally well be compelling reasons why preserving their capital is paramount so they would stick to the 4% withdrawals rule.
The simple fact is that all of our situations are different. There will be different tax implications of different approaches depending on our circumstances. Health, life expectancy, and a desire to leave a legacy are also factors.
Few of us are honestly emotionally equipped to deal with such thorny issues as how long we would be expected to live and make adjustments to our own financial plan to suit.
For the complex task of retirement planning, we should not be shy to reach out and seek expert advice. This article explains some of the facets of seeking financial planning advice.
Questions and answers
Q. What is the safest investment for retirees?
A. There is no such thing as a single safest investment for retirees. As this article has demonstrated you need a diversified portfolio of liquid assets with high expected returns whose returns are not correlated. The worse thing that can happen in retirement, financially speaking is to run out of money. With current interest rates so low, the traditionally safe investments of Treasury bonds will not keep pace with inflation.
Q. What is the best asset allocation for retirement?
A. This article has demonstrated that an approximately even allocation across the different classes of stocks, high return bonds, and real estate delivers good results. I refer back to our table of annual returns for each asset class above.
We could probably do some fancy mathematics that would derive an optimal asset allocation based on either the last 20 years or 30 years or different periods depending on whether we wanted to maintain purchasing power or preserve capital as our primary goal.
Or if we could convince ourselves that the expected returns and variance of returns of each class are more or less stable, we could use those statistical figures to derive optimal allocations. However, as is always the case though, past performance is not necessarily an indication of how assets will perform in the future. So it is best to stick with a system that is rational and can be easily managed.
Q. How much do I need to retire?
A. Using this total portfolio approach, you need to retire on an income of approximately 80% of your last salary. If you withdraw 4% per year to retire, you can calculate the total amount you need to retire as equal to your last salary multiplied by 0.8 and divided by 0.04. That is the same as 20 times your last salary.
So if you earned $100,000 you will need a sum of $2 million to retire if that is your only source of income.
Affiliate Disclosure: This article contains affiliate links, if you purchase through a link on this site, I may receive a commission.
Are you ready to get serious about investing in your own financial education? Then check out membership of the American Association of Individual Investors, the AAII.
The AAII is a nonprofit organization, dedicated to the financial education of its members. Your membership of the AAII will give you access to courses and resources on stock investing, financial planning, and how to manage your retirement finances.
I hope you found this article interesting and useful. Do leave me a comment, a question, an opinion, or a suggestion and I will reply soonest. And if you are inclined to do me a favor, scroll down a bit and click on one of the social media buttons, and share it with your friends. They may just thank you for it.
Disclaimer: I am not a financial professional. All the information on this website and in this article is for information purposes only and should not be taken as personalized investment advice, good or bad. You should check with your financial advisor before making any investment decisions to ensure they are suitable for you.
Affiliate Disclosure: This article contains affiliate links. If you click on a link and buy something, I may receive a commission. You will pay no more so please go ahead and feel free to make a purchase. Thank you