Investing in Retirement

Call this an aspirational post, because at the time of writing, I’ve got a long way to go before retirement.  Maybe it’s wishful thinking, or maybe it’s a case of wanting to plan for the future, but either way, let’s hope it doesn’t hurt to plan too much in advance.  After all, maybe one day I can look back at what I originally thought might be a prudent strategy and see whether I was close or if I learned much more along the way.

The traditional wisdom you’ll often see for retirees is to shift to a less risky investment portfolio as they near retirement, and then minimize risk even further once there.  The “standard” practice, if you will, mostly consists of shifting from equities (i.e., stocks) to fixed-income assets, such as bonds, or, in certain scenarios, annuities (I stand behind my aversion to annuities).

This traditional strategy might be acceptable if you retire at 65 and think you’ll maybe have another 20 years or so to live.  It’s also perhaps better suited for a retiree with just about enough saved up to retire, albeit on a tight budget and maybe with a boost from social security.  If you’re 65 and take this approach, you try to make the math show that you’ll make it to the end without running out of the cash you need to survive, hopefully with a little left over for the family. 

But what about if you retire at 45?  You’ve got to stretch that money over a much longer time period and you can’t count on social security for at least another 20 years (my take on social security is never to rely on it).  Unless you’ve doubled or tripled what you think you’d need in retirement, you obviously have to adjust to stretch your money for longer.  After all, you really want to avoid running out of money in your late 60s when you’ve been out of the work force for over 20 years.  You won’t be as employable, and let’s face it, going back to work at that point would be a significant change for the worse.

The simple answer to maximizing the chances of having enough retirement money is to retain more risk in your portfolio when you retire.  This means that if you retire at 45, you’ll keep a greater share of equities, equity-based ETFs, and mutual funds than someone who retires at 65.  You’ll also have fewer investments in fixed-income assets like bonds and certain types of preferred stock.

But because you’re living off your investments, you might think that you don’t want to take on the same risk profile as someone who’s still working and has that as a fallback.  So, how do you find the appropriate balance between the risk you need to stretch your funds and the security you need to avoid money troubles if the market goes down?

Before getting into the potential strategy for investing during early retirement, I first want to address the concept of taking on risk in the early years of early retirement.  And here it is – if you’re 50, you’re still essentially a long-term investor, meaning that you can afford a risky profile, even if you’re technically retired.  What I mean by this is that you probably don’t need to be as risk averse as the traditional wisdom might dictate for someone who retires much older, the reason being that if there is a downturn, your investments have time to recover.  This does rely on the notion that you’ve planned well enough that you’re not intending to spend 100% of your portfolio value right away.

An example is the only way to do this concept justice.  Say you’re 50 and have been retired for a few years.  Your portfolio has a market value of $1.5 million and you’re holding about 80% of it in stocks, projecting a continued 6% return for the foreseeable future.  Then, a shock hits the market and the market value of your portfolio goes down by 40%, leaving you with $900k in market value.  This scenario is not entirely out of the realm of possible – the market dips in 2001, 2008, and 2020 had people (temporarily) losing around this much in market value.  

Unless you were planning to spend all $900k in your 51st year – which would be terrible planning since you would have budgeted to wipe yourself out – you still have $900k in market value that you could theoretically live off.  And as history has shown us, the market is likely to recover.  In fact, in the years following a downturn, we usually see the most significant rates of growth.  Again, look at the years following the dips in 2001, 2008, and 2020. 

Even conservatively, based on history, you can expect to see that market value prop back up to $1.5 million in a few years.  Can you absolutely rely on the same thing to happen?  No.  But more than likely there will be a rebound of sorts, if for nothing other than the fact that depressed stock prices often lead to major investors buying the dip.

Let’s take the example further.  Say that with $1.5 million at age 50, you expected to spend about $60,000 per year in retirement.  Assuming a conservative 5% return with 3% inflation, spending $60,000 per year takes you to about age 85 before you start running into trouble. I’m not showing that math here, but it’s calculated the same way as I’ve shown before. 

If suddenly your net worth drops to $900,000 at age 51, then with the same assumptions, you make it to about age 68.  That is, assuming a 5% return, except starting at $900,000, you make it to age 68 before the money runs out.

While that might sound scary, the takeaway is that you’re not destitute at age 52 or 53.  You have some time for your account to recover.  And if we go by history, a 5% return after a 40% dip is not realistic.  In those subsequent years, the return is likely to be much higher, particularly if the economy gets a boost from the federal reserve.  (It’s safe to assume that an economic shock is what resulted in the 40% dip, which is very likely to be the target of a boost from the Fed). 

Remember the assumptions about an average 6% rate of return. That “average” assumes there are years when it’s higher and years when the rate of return is much lower.  If you research historical returns of the S&P 500, any of the “average” rates of return – whether 7, 8, 9, or 10% – factor in the years with significant declines.  That is, they include the approximate declines of about 12% in 2001, 22% in 2002, 37% in 2008, and 6% in 2018.  If you look at the years following those significant declines, the gains are much higher than 6%: around 28% in 2003, 26% in 2009, and 31% in 2019.  Not to mention the massive downward swing in 2020, followed by the near-immediate rebound.

Again, the fact that this happened in the past does not necessarily mean it will happen again like this in the future.  But, it’s hard to imagine that these fairly strong trends will disappear entirely. 

So what does this mean for the 51 year-old investor who experiences a 40% decline in their market value?  For starters, it means that continuing to hold is the only way to recoup any losses and that panic selling is, based on historical trends, the worst thing to do.  

But does it also mean that a FIRE investor need not reduce the risk in their portfolio when they retire?  It does sound like that’s what I’m saying.

And in a way, that is what I’m saying.  Everyone has a different risk tolerance and some will likely want to avoid even the chance of having to live through a market decline putting a temporary dent in their net worth while they’re living off that money.  Totally understandable. It’s one thing to take that ride while you’re still working and have another source of income to fall back on. Assuming the economic shock doesn’t impact your employment, which it very well might.

If you do plan to reduce the share of equities in your portfolio after you retire, remember that you have to account for that in your long-term plan.  And you do that by decreasing the expected rate of return in retirement.  So if you’re going to hold 50% bonds and 50% equities, make sure that the return you’re expecting is less than 6%.  What this ultimately means is that you’ll likely have to get to a higher net worth before you can retire, which may entail working longer.  Again, which is fine – it’s not like you’ve failed at FIRE, you’re just adapting your retirement strategy to your risk tolerance.

There may also be the FIRE investor who won’t make adjustments in their portfolio after retirement and will continue to assume a 6% rate of return in retirement.  This may still be feasible given how we’ve seen the market behave, but you’ll have to stomach the bear markets, recessions, and so on.  If you’ve got the gastrointestinal fortitude, then proceed as desired.

There’s always the risk that something could happen that could severely impact the value of your investments to the point that you have no choice but to find another source of income.  And, generally speaking, the more equities you hold, the higher this risk.  Of course, the risk is not gone altogether even if you have more fixed-income assets, but it’s generally lower – if history continues to hold up.

So what’s the takeaway here?  There are a few:

1. Don’t think that you have to make a massive adjustment in your portfolio as you near retirement and when you retire.  While you want to consider a shift to less risky or less volatile assets, for a FIRE retiree, it’s not necessary to undertake the sort of fundamental shift in risk you might generally hear about for retirees.  

2. If you do plan to shift assets, consider the tax implications.  If you plan to sell stocks to buy bonds, remember the capital gains taxes you’ll incur, which might further water down the incentive to shift assets, particularly if you’re doing this when you’re still working and likely have a higher marginal tax rate than you will in the future.

3. While there’s nothing wrong with taking a less risky approach, remember to factor a lower rate of return into your calculations of how much money you’ll have available in retirement.  You likely won’t get the same return with a greater proportion of fixed-income assets as you would with a more equity-heavy portfolio.  You have to account for the rate of return you expect to see in retirement into the net worth you need to retire.

4. If you decide to keep an equity-heavy portfolio, you’ll likely see more volatility in retirement.  But if you can deal with watching the value of your portfolio bounce around, history has shown that buy and hold will keep you on a relatively upward trend over the long-term.  Just make sure to make any adjustments needed so that you have enough liquidity at a given time to meet your needs.

5. How you decide to invest in retirement is similar to how you invest generally.  It all comes down to our personal preferences.  Some can accept more risk while others like more certainty.

6. Finally, FIRE is a departure from the conventional retirement track of saving up to retire in your 60s.  It’s inherently more risky because the goal is to forego a more stable income stream to live off investments.  The fact that you may have to take on greater risk in your investments while retired is naturally part of the bargain.