Nobel laureate Bill Sharpe says figuring out what do to with your money after you retire is “the nastiest, hardest problem in finance.”
It’s made even harder during weeks like this one, on course to be the worst on Wall Street in years. It has served as a reminder to investors that putting money in the stock market is not a sure thing. This is unwelcome news if you are about to retire and plan to spend down your savings. Will the current correction turn into a full-blown bear market? It is always a possibility. If you are about to retire, it is worth asking: should take all your money out of the stock market?
It depends, of course.
You probably can’t afford to avoid stocks
The stock market may be risky, but that risk comes with higher expected returns. You can eliminate risk by parking money in bonds or buying an annuity. Based on Federal Reserve data, the average American over age 60 in 2016 had $180,000 their retirement account, which works out to about $8,600 a year in income.
Since most people have not saved enough to retire risk-free, the average retiree’s investment portfolio is 40% in stocks just before, after, and well into retirement.
You probably own a target date fund
Instead of whether you should be in or out of equities altogether, a better question to ask is how much of your retirement savings should be in the stock market. You probably need to take on some risk to improve the odds of increasing your wealth, but it is also prudent to hedge and put some money in lower-risk assets, so you don’t have to bear the brunt of all the volatility if it strikes at an inopportune time, like retirement.
According to estimates from the Investment Company Institute, about 20% of assets in employer-sponsored retirement accounts in the US are invested in a target date fund. (Nearly 70% of target date funds’ assets come from company-sponsored retirement accounts.) A target date fund shift portfolios into bonds and out of stocks as the owner approaches retirement. The idea is that there exists some perfect balance between stocks (risky) and bonds (safe-ish)—for argument’s sake, let’s say this is 40% in stocks and 60% in bonds.
As you age, your future labor earnings, which are bond-like, make up a smaller share of your overall wealth. Young people tend to have almost no savings and many years of future earnings ahead of them, so their “portfolios”—current and future savings plus earnings—are more than 90% invested in bond-like assets. That’s too much, many would argue, so most target date funds are set up to invest nearly all of a young person’s savings in stocks.
As future earnings become smaller relative to savings, you need buy bonds to maintain a 40% ratio. That’s why target date funds shift into bonds as owners age. And then, one day, you’ll retire and future labor earnings fall to zero. Since target funds gradually build up bond holdings over time, retirement does not warrant suddenly selling all the stock you own. That is, unless you can’t stomach the risk, in which case you shouldn’t be in stocks in the first place.
According to Morningstar, the average target date fund is about 40% in equities when people reach retirement. They tend to keep the allocation around that share all through retirement. But just because that is what target date funds do, it doesn’t mean that 40% in stocks is right for you.
How much is enough?
How much you should put your post-retirement savings in stocks depends the answers to a few different questions:
1️⃣ How much risk can you tolerate? The less you can stand, the lower your equity allocation should be.
2️⃣ What are your spending needs? Prudent advice suggests financing your daily necessities and medical expenses with safe assets, like bonds or an annuity, and using money from your equity portfolio for discretionary things like travel.
3️⃣ How well funded are you? If you have saved enough before retiring, safe bond investments or an annuity can cover spending so you may not need to take any risk on stocks. Or if you have a steady income source in retirement, like a defined benefit pension, annuity, or part-time earnings, you can afford to take more risk because your wealth already features a bond-like asset.
The recent market turmoil is a reminder that the stock market offers no guarantees. Whether you are approaching retirement soon or not, it’s wise to establish a risk strategy that strikes the right balance between stocks and bonds, and stick to it as markets do what they do.
Correction: A previous version of this post said 68% of assets in employer-sponsored retirement accounts in the US are invested in a target date fund. It should be 20% of assets in these accounts; 68% of assets in target date funds come from company-sponsored retirement accounts.