Outline:
The most feared scenario for every retiree is depleting their savings during retirement.
Approximately two-thirds (64%) of participants in a survey conducted by the Allianz Center for the Future of Retirement expressed greater concern about exhausting their savings than about passing away (1). However, what if you could not only reduce this risk but alsoboostcan you boost your retirement savings by making a minor change in how you distribute your funds?
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That’s the core idea behind research carried out by financial specialists Michael Kitces and Wade Pfau in 2013 (2). Their examination of historical performance across various asset categories indicates that a non-traditional method of portfolio allocation might significantly impact your likelihood of a successful retirement.
In reality, with optimal conditions, you might end up 500% wealthier compared to someone using a traditional method for retirement investing. Let’s examine the numbers more closely.
Unconventional allocations
Most older adults and financial advisors rely on a basic guideline known as the rule of 100 to manage investment distribution during retirement (3). This involves subtracting your age from 100 to find out how much should be invested in bonds, with the remaining amount going into stocks.
If you are 60 years old, 60% of your investment portfolio would be in secure bonds while the other 40% is allocated to stocks. As you age, you gradually move a larger portion of your funds into bonds.
This traditional method relies on the idea that as people age, they tend to be less willing to take on risk. For example, if you’re in your 80s, you may not have enough time to recover from a significant drop in the stock market. Slowly increasing the amount of bonds in your portfolio as you grow older helps lower this risk and minimize fluctuations.
Nevertheless, this method raises sequence risk, which is the possibility that a retiree faces a significant decline in stock values during the beginning of their retirement, as noted by Kitces (4). For instance, if a 60-year-old retires with 40% of their funds invested in stocks and encounters a bear market at the start of their retirement, this could permanently lower the value of their savings over time.
This is why Kitces and Pfau advocate for an unusual reverse strategy in portfolio distribution. Rather than following the basic 100 rule, they recommend that retirees hold a larger portion of their funds in safe bonds during the initial five to seven years. This approach reduces vulnerability to stock market declines and allows more time for the benefits of compounding to take effect.
Their evaluation indicates that this method might lower the likelihood of failure, or the risk of depleting funds during retirement. The probability of success using this unexpected strategy may reach up to 95.1%, in certain situations (4). Additionally, in some cases, it could result in a significantly larger portfolio later on in retirement.
Learn More: The typical net worth of Americans is unexpectedly $620,654. However, it holds little significance.Here’s the key figure (and how to make it rise rapidly)
Best-case scenario
Kitces and Pfau evaluated their strategy under various situations, with the most favorable outcome being the prevention of a stock market downturn during the initial years of retirement.
Imagine two retired individuals, Geoff and Gisele, who both begin their retirement in the year 2000 with $1 million each. They intend to withdraw $40,000 annually from their investments. Geoff’s approach is to initially allocate 80% of his portfolio to stocks, decreasing this percentage to 20% over the course of his retirement. In contrast, Gisele will start with only 20% of her portfolio in stocks, gradually increasing it to 80% by the end of her retirement period.
Both individuals faced the 2001 dot-com crash immediately. However, Geoff was more affected by this event and had to sell his stocks during a decline to support his yearly withdrawal. In contrast, Gisele could depend on income from her bond investments and suffered only a minor impact from the market downturn.
This experience has enduring effects on both investment portfolios. Considering market returns over the following 23 years, Gisele’s portfolio would reach $1.5 million by 2023, whereas Geoff’s would decrease to only $316,765.
In other words, Gisele’s portfolio would be almost 500% bigger than Geoff’s, solely due to her investment strategy and the timing of a market crash during retirement.
To be specific, this is just one possible situation involving multiple assumptions. However, it highlights the significant effect of avoiding sequence risk during retirement. No matter what the market’s future returns may be, adopting Kitces’ method might present less risk for most retirees, even if it feels unconventional.
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Article sources
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NBC 4 New York (1); SSRN (2); Corporate Finance Institute (3); Kitces (4)
This article offers information solely and should not be interpreted as guidance. It is made available without any form of warranty.