Monday, March 24, 2008

Investing During Retirement

When we save for retirement, we tend to focus on that magical day when we will stop working. However, you won’t need to withdraw your entire retirement savings all at once on that day. For the most part, you’ll just need a certain amount per month plus the odd larger amount for things like a car, boat, or skydiving gear.

Your retirement could easily last for more than 20 years. So, you’ll have to continue making decisions about how to invest your savings after you’ve retired.

Most people (including me) believe that it makes sense to invest more conservatively as you get older. This usually means increasing the amount of money you invest in bonds and cash rather than stocks. In his book “Rational Investing in Irrational Times”, Larry Swedroe offers the following guidelines for percentage of money in stocks vs. how long it will be until you need the money:

0-3 years: 0%
4 years: 10%
5 years: 20%
6 years: 30%
7 years: 40%
8 years: 50%
9 years: 60%
10 years: 70%
11-14 years: 80%
15-19 years: 90%
20 years or longer: 100%

I discussed how reasonable this advice is here and here. But, let’s just take this table at face value for now.

It is easy to misinterpret this table. It doesn’t refer to the number of years before retirement. It refers to the number of years until you’ll need the money.

Think of splitting your retirement savings into many separate pots, one for each month of your retirement. (This is just a mental exercise – you don’t actually have to split your money up.) On the day you retire, your first 3 years of monthly withdrawals will not be in stocks at all. However, your monthly withdrawals planned for 20 years from now will still be 100% in stocks.

Let’s say you are planning a 25-year retirement. That’s 300 monthly withdrawals. At any given time each one of these monthly amounts has its own percentage of allocation to stocks. It would be nice to blend these percentages together to get the overall percentage allocated to stocks.

I worked out the stock allocation based on the following assumptions:

1. You’ll withdraw the money steadily each year of retirement in amounts that grow with inflation.
2. Your stocks will grow at an average compound rate of 6% above inflation.
3. Your fixed income investments will average 2% above inflation.

I rounded the results to the nearest 10% partly because exact figures are pointless and partly to shrink the size of the resulting table. Here are the results:

Before Retirement:
14+ years before: 100% in stocks
8-13 years before: 90% in stocks
6-7 years before: 80% in stocks
4-5 years before: 70% in stocks
1-3 years before: 60% in stocks

After Retirement:
0-4 years after: 50% in stocks
5-10 years after: 40% in stocks
11-13 years after: 30% in stocks
14-16 years after: 20% in stocks
17-18 years after: 10% in stocks
19+ years after: 0% in stocks

So, it turns out that following Swedroe’s advice, we still have half our money invested in stocks for the first few years after retirement. The assumptions that went into these calculations may not apply to everyone, but for almost any set of reasonable assumptions, retirees still need to allocate some of their savings to stocks.

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