Consider all your sources of retirement income when making asset allocation decisions in retirement.
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In order to protect existing assets, retirees and their advisors are understandably concerned about avoiding financial losses due to stock market downturns. The primary concern is that if any losses occur, the retiree won’t have the ability or time to make up for them.
This concern is often reflected in the way that retirees allocate their assets between stocks and fixed-income investments. When making these asset allocation decisions, however, retirees and their advisors often ignore the fact that most retirees have income sources that are protected from investment losses, such as Social Security, and pensions and annuities, if applicable. By ignoring these other sources of income, advisors and retirees may not be choosing the best investment vehicles for the invested savings.
Let’s take a look at an example that illustrates this point, taken from my recent book, Don’t Go Broke in Retirement.
Jack and Mary: Investing for Retirement
Hypothetical couple Jack and Mary have $400,000 in savings that they can devote to generating retirement income that will supplement their Social Security benefits. Let’s suppose they both retire at age 65, and at that age, they start their Social Security income and deploy their savings to generate retirement income.
They estimate that their total annual retirement income is $49,670. Of this amount, a little more than three-fourths (76%) of this income comes from Social Security, which is protected against investment risk, inflation risk, and longevity risk. (The fact is, most middle-income retirees will have a high degree of risk-protected retirement income.) A little less than one-fourth (24%) of their income is generated from their savings and is subject to these risks.
If Jack and Mary invested 100% of their total savings in stocks—which is highly unlikely—three-fourths of their total retirement income would still be protected from investment risk. If, however, Jack and Mary invested their savings in a common target date fund for retirees, about 50% of that fund would be invested in stocks. In that case, about 12% of their total retirement income would be subject to investment risk.
This analysis might make Jack and Mary consider taking some calculated investing risks for the potential to grow their savings—and their retirement income—throughout their retirement.
One way to increase risk-protected retirement income
Suppose, in the example above, that Jack and Mary use a portion of their savings to fund a Social Security bridge payment, which enables them to delay starting Social Security beyond their retirement date (age 65). This strategy will significantly increase their total Social Security income.
The Social Security bridge strategy increases Jack and Mary’s total annual retirement income at age 65 from $49,670 to $55,499. The strategy also increases their portion of risk-protected retirement income from 76% to 89%.
In this case, they could invest 100% of their remaining savings in stocks and still just have 11% of their total retirement income subject to investment risk.
The fundamental investing dilemma for retirees
The essential investing issue facing retirees is that most of the time, but not always, they’ll realize greater returns throughout their retirement by investing a substantial amount of savings in stocks. You can see the evidence for this observation in the paper linked below, which uses historical data to give you a visceral feel for the opportunity—and risks—of investing in stocks throughout retirement.
Investing in stocks has the potential to generate greater returns over time, thereby increasing retirees’ income and helping protect them against inflation. The investing dilemma comes from the “not always” part about higher stock market returns—the higher returns definitely aren’t guaranteed.
As a result, retirees and their advisors will need to devise smart strategies that will make them feel comfortable with the amount of investment risk they assume in retirement. Looking at the picture of their total retirement income is sure to help them make more informed decisions.