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***HOW DOES THIS RELATE TO INTEREST RATES, PRESENT AND FUTURE VALUES****

 

 

Experts are starting to rethink how much stock people should hold in retirement.

In general, the new thinking goes, people should be more heavily invested in equities than is suggested by some traditional rules of thumb, such as subtracting one’s age from 100 to determine a portfolio’s stock allocation. One new, and controversial, theory even goes so far as to suggest that stock exposure should increase the further one moves into retirement.

What hangs in the balance: whether 78 million baby boomers can generate sizable enough returns, without taking on too much risk, to create income streams that last as long as they do.

Here are three different approaches financial experts are pushing, all of which conclude that people should be investing more heavily in stocks–even after they’ve collected the gold watch:

One of the biggest risks in using investments to fund retirement is what’s called “sequence of returns” risk. If you retire and your investments take a big hit during the first few years you’re making withdrawals, the money will run out years earlier than if you have decent returns earlier and suffer through a market downturn later.

To combat the problem, two researchers recently crunched the numbers and concluded that, in many cases, investors should dial back their stock holdings to between 20% and 50% at the start of retirement and then ramp them back up by one percentage point a year to between 40% and 80% throughout retirement. For example, a portfolio that starts at 30% in stocks and finishes at 60% performs better on average than one that starts and finishes with 60% stocks.

“You want to have the lowest stock allocation when your portfolio is largest, and that’s going to be right before and after retirement,” says Wade Pfau, a retirement-income professor at American College in Bryn Mawr, Pa., who did the research with Michael Kitces, research director of Pinnacle Advisory Group in Columbia, Md. “That’s when you’re most vulnerable to losing wealth. Once you transition into retirement, you no longer have as much ability to change your plans and make it back up.”

The researchers describe their asset-allocation recommendation as a “U-shaped glide path,” where stocks start as a large share of the portfolio, decline, and then are increased over time. Ideally, the researchers say, they would like to see their recommendation incorporated into the asset allocations used by target-date funds, which base their allocations on retirement dates and ages in an attempt to allow investors to put their investment goals on autopilot, Mr. Pfau says.

So far, though, target-date funds, at best, keep a fixed portion of assets in stocks through the retirement years, and most have a declining share in equities. “They’re exposing you to potentially worse outcomes by having a declining glide path in retirement,” Mr. Pfau warns.

Says Mr. Kitces: “If I say, ‘You’re going to invest more in equities later in retirement,’ everyone freaks out.” But he and Mr. Pfau say retirees’ actual behavior in the past, when more people relied on traditional pensions, matches up to their findings.

People funding their fixed costs with a combination of a pension and Social Security or other annuity payments sometimes invested much of the rest of their assets in stocks, Mr. Pfau says. So, as they aged and the remaining value of those fixed-income sources effectively declined, they essentially had more of their investments in stocks.

For years, many financial planners advised investors at retirement to weight their portfolios heavily to bonds. Some now argue that the main underlying assumptions behind that recommendation no longer apply.

For one thing, “we’re ending a 30-year bull market in bonds,” says Lisa Shalett, head of investment and portfolio solutions for Morgan Stanley’s Morgan Stanley Wealth Management. For another, the investment horizon for most retirees has lengthened to 30 years from 10, along with the general rise in longevity for the U.S. population. And lastly, the shift from pension plans to 401(k) retirement plans has more retirees depending on investment gains for income.

“You put those three things together, and what it says is we need a new approach,” Ms. Shalett says. Bonds can no longer be counted on as the driving engines in portfolios that may have to last three decades.

As an alternative, Morgan Stanley recently came up with a new take on the commonly used “bucket” approach to retirement income. Traditionally, buckets are divided into one for a few years of cash, then a couple for investments for five to 20 years out. Ms. Shalett’s approach generally starts by dividing a portfolio into five equal buckets of different risk levels.

The retiree pays expenses from the lowest-risk bucket, holding cash, short-duration bond funds and money-market funds. Each year, money is transferred from buckets two through five to the first bucket to keep the balance in the cash fund sufficient to cover five years of living expenses. Buckets two through five are adjusted annually to be equal to each other in assets and so that each keeps its initial asset mix.

In one example from Ms. Shalett, bucket two would be 80% intermediate bonds such as Treasurys, investment-grade corporate and municipal bonds, and 20% equities. Bucket three would have a 50-50 bond/stock portfolio with some high-yield and emerging-markets international bonds and international stocks. Bucket four would have a 70/30 stock/bond mix taking tactical positions, such as, “This year, we like tech stocks,” she says. The fifth bucket would be all equities and other assets with significant risk, including commodities, real estate and private equity.

In this example, the portfolio starts at roughly 50% stocks and other risky assets. The mix in later life will depend on market performance; if markets boom, the risk-asset share could grow.

But “at any given time, the next five years of your expenses are fully funded in cash,” Ms. Shalett says. She says that is critical to help risk-averse retirees feel comfortable with significant equity exposure and avoid bailing out when prices periodically tumble. “It’s that peace of mind that gives you the ability to absorb the volatility in stocks,” she says. “It’s the behavioral aspects of this that we’re trying to attack.”

For years, Vanguard Group founder John C. Bogle has said that investors, as a starting point, should have a bond allocation roughly akin to their age–the usual rule of thumb. But an important detail often got lost: He says that the “bond” part should include any pension, along with Social Security.

For retirees, in practice, that could mean a higher allocation of the actual investment portfolio in equities.

Most people around age 65 can estimate the overall value of their benefit in today’s dollars by multiplying the annual amount by 15, says David Blanchett, head of retirement research at Morningstar Inc.’s Morningstar Investment Management. For example, if you receive $20,000 a year in Social Security, the value of those payments as an asset would be about $300,000, he says.

Using the basic rule of thumb, a 65-year-old retiree with $1 million in investments would keep $650,000 in bonds and $350,000 in stocks. But say that retiree also has Social Security benefits valued at $300,000. That would raise the overall portfolio value to $1.3 million. As Mr. Bogle applies the formula, this individual could invest $545,000 in bonds after subtracting out that $300,000 Social Security value. And he could risk $455,000 in stocks.

Investors who are later in retirement and weighted heavily in bonds with low yields may also want to consider adding more stocks to the mix, he says.

Says Mr. Bogle, “It’s an option for people in their older years badly in need of income.”

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