The conventional retirement wisdom is that you should hold a well-diversified portfolio of stocks, bonds, and cash in a proportion that grows gradually more conservative as you age. You can even purchase a target-date fund that will shift the asset allocation for you. But some academic researchers say this approach to retirement investing is dead wrong and believe there are smarter ways to grow and protect your nest egg. These unconventional retirement strategies aren't necessarily easy to impliment and the economists call their own strategies "audacious" and "revolutionary". Here is how several leading professors say you should invest for retirement.
Borrow to invest. Retirement savers typically aim to invest more in the stock market when they're young and less when they're old. But entry-level workers generally don't have more than a few thousand dollars annually to invest—far less than they will be able to invest in their 50s. Yale economists Ian Ayres and Barry Nalebuff make the case that young people should borrow money to invest in the stock market in order to lower their lifetime stock-market risk. In their new book, Lifecycle Investing: A New, Safe, and Audacious Way to Improve the Performance of Your Retirement Portfolio the researchers suggest that young people use a margin loan from a broker or purchase a call option to invest 200 percent of their retirement savings in stocks. While the amount investors have at retirement is dependant on stock market performance, Ayres and Nalebuff calculated that the range of possible portfolio balances upon retirement are smaller using this strategy. The best possible outcome isn't as high but the worst final balance won't be as devastating.
Using a loan to invest in index funds when they're young allows investors to diversify across time in a way that's similar to using a mortgage to buy a house, according to the researchers. "You want to spread your exposure better across time," says Ayres. "It gets you closer to well-diversified." But borrowing to invest doesn't mean picking stocks or taking unnecessary risks. Ayres says you shouldn't pay more than 1 percent above the current Treasury rate to borrow on margin. A competitive interest rate is currently about 1.5 percent. And young retirement savers should maintain that 2:1 stock market exposure only for the first 10 years of their career. After that investors should gradually reduce the borrowed amount and have no outstanding loans after 25 years in the workforce.
Protect your nest egg. The only thing that can truly protect your retirement savings is investing in safe assets such as Treasury Inflation Protected Securities, a type of government bond guaranteed to beat inflation. Zvi Bodie, a Boston University finance and economics professor, compares investing your retirement savings in the stock market with high-stakes gambling. "When you do invest in stocks, don't kid yourself into thinking that it's safe. It's not," says Bodie. "The more you invest in stocks, the greater your exposure to risk in the long run, just as in the short run." If the stock market dips shortly before or after you retire, you will have less money available for spending in retirement. The co-author of Worry-Free Investing: A Safe Approach to Achieving Your Lifetime Financial Goals says investors looking for a guaranteed return should pull their nest eggs out of the stock market and put the money into TIPS.
[See To Stay Safe, Sell Stocks.]
Bodie, who has 100 percent of his retirement portfolio invested in TIPS, says he's not opposed to any investment in stocks, but thinks retirement savers should keep the bulk of their retirement investments in safe assets. Investors should also consider their job security and other sources of income when deciding how much to invest in stocks. "You don't want to have a big exposure to stocks unless or until you are pretty confident about your working income," says Bodie. If you do decide you have the stomach for stocks, keep TIPS in your IRA or 401(k) and hold equities outside tax-deferred accounts to minimize your tax bite, Bodie says.
The roller-coaster portfolio. In addition to a diversified portfolio, retirement savers need to diversify their total assets, which may include current and future work income, employer provided benefits, housing, and government benefits. Boston University economics professor Laurence Kotlikoff and financial columnist Scott Burns argue in their book Spend 'til the End: The Revolutionary Guide to Raising Your Standard of Living Today and When You Retire that you should reduce the share of your resources held in stock in years when you have more uncertainty about your earnings and increase stock market exposure when you have more predictable sources of income. Using this strategy your income from working should be counted as if you are holding bonds for that amount. "The basic idea here is you want to have a balanced portfolio between stocks and bonds throughout your life and earnings are treated like holding TIPS," says Kotlikoff. "If you are trying to achieve this balance, the portfolio allocation is kind of dictated by how these other TIPS-like things are changing through time."
For most people, diversifying total assets results in a roller-coaster retirement portfolio that calls for holding a moderate share of financial assets in stocks when young, increasing stock allocation dramatically in middle age, and reducing it as retirement approaches. There's a second twist in the wild ride. Kotlikoff and Burns, who used the retirement-planning software ESPlanner to reach their conclusions, also call for retirees to modestly increase the amount of stock they hold early in retirement and decrease it dramatically later in retirement. "When you hit retirement age then you should start going back up because you start taking Social Security and pension benefits, which are safer than labor income," says Kotlikoff. But stock exposure should be decreased later in retirement as you develop more uncertainty about your health expenditures.