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Q. Why is the recommended mix of stocks and bonds any different at the beginning of my career than at the start of retirement? I don't understand why I should reduce my exposure to stocks when I retire, as I'll still have 30 years of investing ahead of me. -- Gordon Groff, Lancaster, Pa.
A. You're right. You should be investing for the long term -- both during your career and after you retire. Still, there are some key differences between those two stages of life that argue for gradually scaling back on equities after you retire.
The single biggest difference is that you have a lot more flexibility during your career when it comes to retirement planning. For example, if you have the bulk of your retirement accounts in stocks and the market tanks, you've got plenty of options for rebuilding the value of those accounts.
With years of work still ahead of you, you can simply sit back and wait for the market to rebound and eventually climb to higher ground. Or you can pump up the amount you contribute to your retirement accounts, which will hasten the recovery of your balances.
If worse comes to worse, you can always postpone retirement for a year or two, which will give your nest egg a chance to grow through a combination of additional savings and a few extra years of investment returns.
But if your savings are heavily invested in stocks in retirement and the market takes a dive, you don't have nearly as much wiggle room.
Unlike during your career when you're still putting money into your 401(k), IRA or other accounts, you'll be pulling money out of your nest egg once you retire. And that creates a very different dynamic.
Specifically, the combination of investment losses from a market downturn, plus withdrawals from your account for retirement living expenses creates a double-whammy effect that can decimate the value of your portfolio and dramatically increase your chances of outliving your dough.
As a result, the same market meltdown that may be very unsettling during your career can be absolutely devastating after you've retired, perhaps even forcing you to radically scale back your standard of living to avoid running through your money too soon.
Here's an example. Let's say you retire at 65 with $500,000 in savings from which you plan to withdraw an initial 4%, or $20,000, that you will increase annually by the inflation rate to maintain your purchasing power. And let's further assume that you would like your savings to support you at least 30 years.
If you plug that scenario into a good online retirement calculator, you'll find that the chances of your nest egg lasting 30 years are roughly the same -- just under 80% -- whether you invest 80% of your savings in stocks and 20% in bonds or split it 50-50 between the two.
And although the calculator doesn't show this, it's also true that if all goes well and there are no major blowups in the market, the higher returns stocks can deliver might allow you to draw even more from your nest egg than had you gone with the 50-50 mix.
The problem is what happens to those odds if things go badly. For example, if you had retired at the beginning of 2008 with 80% of your savings in stocks and 20% in bonds and embarked on the withdrawal scenario above, at the end of the first year of retirement the combination of a $20,000 withdrawal and a 30% investment loss would have left you with a nest egg worth roughly $340,000 -- a 32% decline in a single year.
If you continued to withdraw $20,000 and increased annually for inflation of, say 3%, the chances of your savings lasting the next 29 years to age 95 would plummet from a little less than 80% to just under 40%.
By contrast, had you invested half your savings in stocks and half in bonds, the combination of your initial withdrawal and the market downturn would have left you with a nest egg worth a bit more than $400,000.
The probability of your money lasting to age 95 would decline. But since your nest egg wasn't whacked as hard, the chances would drop to just over 50%.
Clearly, in both cases you would have to make some adjustments -- going without an inflation increase for a few years, reducing your withdrawals outright or perhaps even taking on part-time work.
The difference is that with the more conservative portfolio, the compromises you would have to make to your retirement lifestyle wouldn't have to be as severe. And you wouldn't be as vulnerable to potential market setbacks in the future.
Now, does that mean that it can never make sense to invest somewhat aggressively in retirement? Of course not.
If income from Social Security and a traditional company pension covered all or nearly all of your annual expenses, then theoretically you may be able to invest quite heavily in stocks.
After all, if your retirement accounts suffered serious losses, you would still have enough income apart from savings withdrawals to maintain your lifestyle (although even then you would have to consider whether you would be emotionally okay watching your nest egg's value decline by 30% or more).
Bottom line: If you'll have lots of income flowing in throughout retirement from guaranteed sources -- or your nest egg is so large or withdrawal rate so small that your chances of depleting it are truly minimal -- then I suppose you could invest the same way late in life as you did at the beginning of your career. But if that's not the case -- and I suspect it's not for most of us -- the more prudent approach is to scale back your stock exposure as you near and enter retirement.