Retirement savers have become painfully aware of the risks associated with investing in the stock market over the last few years. Some individuals have learned the hard way that their tolerance for risk was not as high as they thought it was during the years in which the market only went up. Many investors allocated far too much of their portfolios to stocks and not nearly enough to the not-very-sexy investment of bonds.
As is often the case with that proverbial pendulum, it may be swinging a bit too far in the other direction now. Is it possible to navigate retirement with a portfolio built entirely of bonds and cash? Yes, but if that’s how you’re going to sail, you’re going to need a bigger boat.
[See How to Retire in a Recession.]
Between 1926 and 2009, a period that includes several recessions as well as the Great Depression, the average annual returns for stocks and bonds were 9.8 percent and 5.5 percent respectively, according to Ibbotson data. Inflation averaged 3 percent.
Most people now realize the dangers of chasing that 9.8 percent by investing all of your retirement assets in stocks. Over the long term stocks have outpaced inflation by a comfortable margin. But the short-term problem of having to sell in a down market just to pay the bills decreases the odds that you will be left with enough to make it through your golden years. But you face another problem if you put all of your retirement money in bonds, CDs, and your mattress.
Let’s assume Jack needs about $50,000 a year to supplement his Social Security income. He’ll of course need a little more each subsequent year to keep up with a 3 percent inflation rate. Jack, 62, was a financial planner, so he has included a cushion for such things as taxes, unexpected home repairs, and replacing his car from time to time. If Jack invests his entire $1.2 million nest egg in fixed income investments and is able to achieve the historical average of 5.5 percent, he will have enough money to make it to his 100th birthday, assuming he leaves nothing to his kids.
Jill, never having had children, is also unconcerned with leaving money to heirs. She retires in the same situation as Jack but has allocated her nest egg 50 percent to the same bond funds as Jack and 50 percent to a diversified portfolio of mutual funds where she is able to achieve the historical average of 9.8 percent. Since her overall allocation is expected to return around 7.7 percent she will only need a nest egg of $900,000 to retire at 62.
In early 2009 Jack and Jill had been so spooked by the market that they considered putting off retirement until they had accumulated enough wealth to retire with 100 percent of their retirement assets in FDIC insured deposits. But then Jack figured out that would require a nest egg of nearly $4 million to accomplish.
By all accounts, most people are having a very difficult time saving enough for retirement. More than half of those surveyed by the Employee Benefit Research Institute haven’t even tried to compute how much they will need. Making the target unnecessarily high by striving for a risk-free portfolio makes that task even more daunting.
Instead of making it impossible, why not settle for reasonably safe? Craft a retirement plan that assumes you will earn lower returns than the historical averages. Assume that inflation will be higher and that your life expectancy will be longer than average. Create a portfolio that includes a broad diversity of assets and be sure to rebalance it regularly.
Sydney Lagier is a former certified public accountant. Since retiring in 2008 at the age of 44, she has been writing about the transition from productive member of society to gal of leisure at her blog, Retirement: A Full-Time Job.