What if your biggest risk is that you don’t own enough stocks?

For retirees I usually recommend a portfolio between 50% stocks and 80% stocks. In other words, the most conservative portfolio I recommend is still mostly stocks. Why is that? After all, stocks are a lot more volatile than bonds, and bonds are currently paying 4% interest, which could theoretically cover annual distributions from retirement accounts, per the 4% rule. 

So why doesn’t that work? 

Clients need to assume that inflation will erode the value of their money, particularly over a long retirement. On top of that, there are usually other financial needs on the horizon that need to be provided for. Replenishing the portfolio for daily living expenses as well as major life experiences is a good example too. And it is also important to create a large enough cushion to pay for longevity risk and long term care. 

Over 25 years, 3% annual inflation takes the purchasing power of a dollar down to just 46.7 cents. With bonds this creates a problem because the interest payments don’t rise with inflation. They offer a fixed amount of income, aka “fixed income.” 

Above keeping pace with inflation, investors also need to replenish the principal they distribute from their portfolio each year. Many distribute between 4% and 5% of their assets. That is a sustainable range, but it means that the portfolio must grow 7-8% in nominal terms to maintain its real, after-inflation value. This calls for a long-term stock allocation in the 60-80% range, slightly above the usual retiree portfolio. 

Lastly, despite growing awareness of the expenses associated with long term care, many retirees don’t have enough saved to cover this expense. These can range from $80,000 to $500,000 per person, and of course, there’s no ceiling on the amount that you might spend. On top of that, there’s no telling when you’ll spend it or what the price tag will be. 30% of people spend nothing at all! For that reason, many retirees are reluctant to set aside such a large lump sum for an expense that may never arise. 

All three of these are substantial risks that need to be dealt with. Risk is not only seeing declines in the value of your investments. The biggest risk, actually, is running out of money. For people nearing retirement, there are only three main ways to lower this risk. 1) They can work longer (many would prefer not to). 2) They can cut their spending or compromise on their bucket list (again, many would prefer not to). Or, 3) they can opt for a higher volatility, higher growth investment allocation. Though market declines are painful, I think they might be the least painful sacrifice of the three.

There are some important caveats to this, though.

It pays to have enough safe reserves to cover living expenses when the market is down, as well as give you enough comfort to sleep at night and stick to your investing plan. These are good reasons for many retirees to start with a more conservative allocation in retirement.

Not only do they have larger expenses associated with just enjoying life, but they usually have 2-3 years before they’ll start Social Security, meaning that everything they spend has to come from their assets. Usually, this means spending well above the 4% rule, though only temporarily.

On the psychological level, I've noticed a couple things while working with retirees. By the time they reach retirement age, their assets have grown so large that even relatively routine market declines of 10-20% are enough to negate several years of saving. But vice-versa for up years. This takes a toll, and my observation is that not many retirees are comfortable with such large fluctuations, particularly when their life's savings is on the line. This is the money that has to last them the rest of their lives, after all. People don't naturally tend to think so much in terms of averages and percentages, as in terms of dollars. And the dollar swings are huge. For this reason, as well as the higher short term cash needs of early retirement, I think there's a good case for starting more conservative and easing into a more aggressive allocation after starting Social Security.