ASK JR: Has the recommended stock/bond allocation changed over the years?Submitted by Financial Planning Hawaii on September 1st, 2017
QUESTION: I'm approaching retirement with a 90% / 10% stock-bond allocation. Traditional retirement planning advice calls for changing this to less stock, more bonds. At the same time, I have been reading that bonds are not what they used to be. What should I do?
J.R.’s ANSWER: “Traditional” retirement asset allocation advice has its roots in a 1994 paper written by California CFP William Bengen entitled "Determining Withdrawal Rates Using Historical Return Data". In the paper, Bengen used a crude historical back-testing methodology to show that the ideal asset allocation for a retirement portfolio was likely somewhere between 50% and 70% stocks and 30%-50% bonds. His analysis also found that inflation-adjusted initial withdrawal rates as high as 4% could be applied to such portfolios with virtually no risk of depletion over a 35 year retirement time frame.
Numerous papers over the past two decades have highlighted both flaws in Bengen’s methodology and the naiveté in his assumptions. One obvious problem in Bengen’s analysis was that the mean interest rate on bonds over the period of time that he tested was far higher than the current historic low yields that investors earn today. Simply put, it is common sense that bond allocations should be much higher when bond yields are contributing 6-7% per year to portfolio returns, but when cash and bonds are paying 0-3%, hefty cash/bond allocations are a drag on returns, and may actually reduce the likelihood of portfolio sustainability.
While most of Bengen’s findings, including the so-called “4% rule,” have been discredited, Bengen’s lasting contribution to retirement sustainability research is his raising awareness of sequence of returns risk – portfolio depletion caused by the misfortune of experiencing severe down markets early in retirement. Using your 90%-10% allocation as an example, if you plan to sell of equities each year to fund your retirement and the stock market happens to tank for a few years (as it did from 2000-2002 and 2007-2009), you may run the risk of running out of money before the market has time to recover. Such was the fate of thousands of unfortunate workers who retired at the end of 1999. Two prolonged 50% bear markets in the ensuing decade sent many retirees back to work.
A fair amount of research has gone into developing strategies to help investors avoid or minimize sequence risk. One common, easily implementable strategy is to maintain 5-10 years of portfolio income in bonds and cash and to spend that portion of the portfolio first. This may seem counter intuitive as the retiree’s stock allocation actually increases in the first decade of retirement as the bonds and cash are spent down. However, research has shown that this can significantly enhance sustainability. A number of more elaborate variations on this strategy exist as well, but the point is that keeping some modest allocation of your portfolio in bonds and cash, even in a low yield environment, can be a useful tool to enhance portfolio sustainability.
Rather than choosing a % allocation, I encourage investors to think more in terms of 5-10 years worth of income allocated to cash and bonds. I also eschew bond mutual funds in favor of individual bonds with maturities staggered over the first 5-10 years of retirement.
For supporting research, see the following article links –
The 4 Percent Rule Is Not Safe in a Low-Yield World (Journal of Financial Planning)
Lifetime Sequence of Returns Risk – Wade Pfau, Retirement Researcher’s Blog
Decision Rules and Initial Withdrawal Rates (Journal of Financial Planning)
The Best Bet for Retirement Income: Bonds or Bond Funds (Investopedia)