Traditional financial advice suggests you invest in a mix of stocks and bonds in planning for your retirement, and shift the mix more towards bonds as you age. The reason for this advice is that bonds tend to be less risky and have lower volatility than stocks, and are often countercyclical to equities. When stocks don't perform well, bonds do, and vice versa.
Research in the 1950s by Harry Markowitz describes an "efficient frontier" to diversifying and trading risk for rewards. Basically, his research showed that there was a point at which you did not need to take on additional risk because the rewards you received for doing so did not justify taking on that extra risk. This research led to modern portfolio theory and much of the well-worn advice that financial planners trot out regarding investing in stocks and bonds.
Unfortunately, one mistake investors often make as they plan for retirement is failing to look beyond stocks and bonds, and take into account other sources of income when they make their investment allocations. However, new research by Dr. Wade Pfau, CFA, threatens to turn traditional advice about stock/bond allocations in retirement onto its head.
Dr. Pfau notes that people have two main goals in retirement: supporting lifestyle spending goals, or at least minimum spending needs, and maintaining a sufficient cushion of assets in reserve for unexpected expenses such as health issues, boomerang kids, and emergency repairs. Since most people do not have enough retirement savings to comfortably meet both goals, they have to make a tradeoff between one or the other—more income or more assets.
While he doesn't claim to allow people to have their cake and eat it too, Pfau suggests that it is possible to get more income in that tradeoff. His research suggests that, instead of investing exclusively in stock and bond allocations, people will be better off in investing in a combination of stocks and fixed annuities while avoiding bonds altogether.
You read that correctly. His research suggests not investing in bonds at all. The paper shows that people have their income spending needs met more fully by buying single premium immediate annuities (SPIAs) and then investing the remaining assets in stocks.
I was intrigued. My grandparents used to buy me Series EE savings bonds for my birthday as a way to save and invest. I had to cash them in to pay for repairs when my car managed to find its way into Mr. Kimble's passenger side door in high school, but boy, was I glad I had them. Surely bonds were part of any well-diversified portfolio, weren't they?
Fortunately, Dr. Pfau was kind enough to spare me some time for an interview. Some highlights:
Regardless of where you are in life, you have to get a handle on your own situation before trying to take advantage of these new findings. If you want to convert some of your assets into annuitized income, then you need to have a good idea of what sort of income you need. Knowing your expenses, or having a good estimate of what your retirement expenses will be, allows you to determine how much in annuities you should be buying.
Pfau has some suggestions for what to consider when looking at a stock-and-annuity asset allocation:
Dr. Pfau's groundbreaking research provides more ammunition for economists who can't figure out the annuity puzzle, and shows that perhaps it's time to trade in the EE bonds for some SPIA annuities instead.
Jason Hull is a candidate for the CFP(R) Board’s certification, is a Series 65 securities license holder, and owns Hull Financial Planning.