Should I Invest Differently When I Retire?

To mitigate sequencing risk, retirees typically shift to less aggressive portfolios as they approach retirement. This shift usually involves reducing exposure to volatile assets like stocks and increasing allocations to more stable investments like bonds or fixed-income securities. After having spent much of their accumulation phase with 60% or more of their investments allocated to stocks, by retirement they typically will have shifted to 35% to 40% in stocks.

Why not eliminate stocks completely? The challenge lies in balancing the need for safety with the need for enough growth to sustain the retiree’s finances over a potentially long retirement period. These days, people frequently reach ages well into the 90s. To support such longevity, a retiree who eliminates stocks altogether at retirement would require a bigger nest egg than most people have.

In this section, the focus is on the crucial understanding of sequencing risk and its implications for asset allocation in retirement. By exploring the need for a less aggressive portfolio and presenting real-life examples, we aim to provide retirees with the necessary insights to navigate this risk. Understanding sequencing risk is essential for any retiree looking to maintain financial security throughout their retirement years.

The insurance approach, advocated by financial experts Zvi Bodie and Nobel laureate Robert C. Merton, among others, emphasizes using retirement savings to secure basic living expenses with certainty. This strategy typically involves acquiring a life annuity instrument whose payments are indexed to inflation. Such an instrument would pay for living expenses for life.

Proponents of this approach often recommend inflation-indexed annuities to protect against inflation, ensuring that retirees’ purchasing power is maintained throughout their retirement.

This approach is particularly appealing to retirees who prioritize stability and predictability over potential high returns. It offers peace of mind by reducing the worry of outliving one’s resources.

In contrast, the investment approach views retirement savings as assets to be actively managed for growth. This method typically involves a diversified portfolio of stocks, bonds, and other assets.

This approach offers more flexibility in responding to market conditions and personal financial needs, focusing on strategic asset allocation and periodic rebalancing.

While this approach involves exposure to market risks, it also opens the possibility for higher returns, which can be particularly important in periods of low interest rates.

The insurance approach focuses on minimizing risks and ensuring stable income, often at the expense of growth potential. The investment approach, however, seeks a balance between managing risks and pursuing potential returns.

The choice between these philosophies largely depends on individual risk tolerance, financial needs, and retirement goals. Some retirees might prefer the certainty and safety of the insurance approach, while others may opt for the flexibility and growth potential of the investment model.

Understanding these two distinct philosophies is vital for retirees. It enables them to make informed decisions that align with their personal goals, risk tolerance, and financial situations, thereby crafting a retirement strategy that ensures both financial security and the fulfillment of long-term objectives.

A major shortcoming of the insurance approach is the lack of available inflation-indexed life annuities. Life annuities abound, and you may buy them with automatically escalating payments. However, insurance companies pre-determine those escalation schedules such that the payout increases have nothing to do with inflation, per se. For most Americans, the only inflation-indexed annuity they will ever see is their Social Security retirement benefit.

Retirees (as well as younger investors) might view income-centric investments as safer and more stable than growth investments. This perception aligns with retirees’ preference for reduced volatility and consistent cash flow.

Retirees seem to prefer to be mailed checks. This preference leads them to want interest-paying bonds and dividend yielding stocks. As do many experts, we view the source of income—whether from investment income or capital gains—as irrelevant, because financial assets are fungible. This perspective promotes a broader view of portfolio management.

Taxes certainly matter. There can be tax-free interest, but there can also be realized capital losses and/or long-term gains whose taxes are lower than taxes from an equivalent amount of taxable interest.

Modern financial planning recognizes the benefits of flexibility in accessing funds. Selling assets as needed can be just as viable for generating income, allowing retirees to adapt to changing market conditions and personal financial needs.

The debate underscores the importance of reflecting on the role of income-centric investments. While they can offer retirees psychological benefits, they are not the only path to financial security in retirement.