Why Retirees Need Equity In Their Portfolios

by Mike Holman

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One of the standard pieces of advice for retirees is that they have to have a very conservative portfolio since they are too old to take any chances with equities. There are “rules” around what percentage of fixed income (ie bonds) a retiree should have. “90 minus your age” is one that I’ve heard a lot.

These rules were probably pretty good guidance at a time when your average retiree finished work at 65 and could reasonably be expected to live for another ten years or so. With a short term investment horizon it didn’t make sense to invest a lot of money in equities because the retiree wouldn’t live long enough to recover from any major losses. Inflation was also not a major concern since the time line was fairly short.

Fast forward to now and there are two major differences in retirees – first of all they are retiring earlier which lengthens the retirement time and they are living longer which of course also increases the retirement time which in turn means that they have a longer investment time horizon so a higher allocation of equities is appropriate. Typically most financial planners will assume an estimate lifetime of around 90, so if an investor retired at aged 60 and lived until age 90 – that’s a 30 year time horizon.

You might be asking – who cares how long the retirement lasts for? Shouldn’t you just be conservative and buy guaranteed fixed income products or annuities and live off the payments? One problem is that while retirees might be living longer once retired, they aren’t working longer, in fact they might even have slightly shorter careers on average so current retirees might not have any more money saved (adjusted for inflation) than someone who retired a generation or two ago and they are less likely to have any kind of company pension plan to help fund the retirement.

The reality is that historically equities have outperformed bonds by a long shot. According to William Bernstein – author of “The Four Pillars of Investing”, two reasons to invest in equities are for the higher expected return and because equities can keep up to rising inflation. If you are retired and your portfolio is entirely fixed income (or annuity) you might run into the problem of a steadily lower standard of living if inflation increases.

Other reasons to invest in equities are that interest is taxed at a higher rate than dividends and capital gains (in Canada and USA) so you will probably be better off if you can only pay dividend and capital gains taxes rather than income tax on interest payments.

What to do?

The answer is two fold. First of all, retirees should have a significant equity holding in their portfolio. Bernstein recommends anywhere between 50% to 75% equities depending on your tolerance for risk. One of the key points that Bernstein emphasizes is that whatever asset allocation you choose, you have to stick with it so pick an allocation that you can handle in rough times. If you choose a higher percentage of equities and then sell when the equities drop and then buy back in when they go up, then you will be further behind compared to if you had just picked a more conservative portfolio and stuck with it. Even if you choose to have an equity allocation of less than 50% then stick with that allocation.

Tomorrow we’re going to discuss the 4% withdrawal rule which will help determine when you can retire.

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{ 6 comments… read them below or add one }

1 The Financial Blogger

We also have to consider that we will not only live longer but healthier too. Therefore, we will probably spend more at 70 (ie travelling, golfing, etc) than our grand parents did.

2 Four Pillars

FB – That’s true but if you are healthy then at least you have the choice of spending money or not on golf. If you are not healthy then you might have to spend money on drugs, care etc. If you are American then health insurance could be a problem as well.

3 deepali

I must work in a unique field – no one in academia is retiring any earlier than before (and most tend to work even longer). My advisor is 80 and still going strong. :)

My generation is living longer and healthier (I’m Gen X). I might argue that future generations won’t live healthier (in fact, it is estimated that the current crop of children won’t live as long as their parents).

4 WhereDoesAllMyMoneyGo.com

Great post Mike!

5 Silicon Prairie

That’s a good point – I’ve been thinking about the way to handle this. After making a few estimates of where I might end up, I noticed that I would definitely want to keep investing in stocks to avoid giving up the returns of the saving years completely.

With a somewhat modest portfolio you might not be able to split it evenly between growth and income and live off the interest of the income part alone, but if you start to take out the principal of that portfolio to allow the growth portfolio more time to accumulate returns, it might be worth it in the long run. Hopefully I’ll be able to make my porfolio big enough that I won’t have to try that :)

6 Four Pillars

Deepali – I don’t have any links to support the idea that people are retiring earlier but I have read that in various places.
Also from anecdotal information I know that at least some people (like myself) are planning to retire early so if that comes to pass then hopefully I’ll have a long retirement.

WDAMMG – thanks.

SP – You should be able to take out 4% of a balanced portfolio inflation adjusted (I’m posting on this tomorrow). It doesn’t actually matter whether that 4% annual value is from interest, dividends or selling investments.

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