Why should a person approaching retirement age make their portfolio less risky?

Question

It seems to be common knowledge that a younger person should invest their retirement funds in growth stocks since they can ride out any market swings. It is also common knowledge that as a person approaches retirement age they should tone it down a bit, investing more in bonds, for example.

Why is this true?

I just ran an online actuarial life expectancy calculator and a person 63 years old today can expect, on average, to live to 87. I put in my pretty average "good health" criteria and I jumped to 93 years.

That's 25 to 30 years. It seems to me that, especially in the early decade of retirement, that you should keep a "risky" portfolio, to maximize your retirement income.

Answer 1

What occurred in 2000 and 2008 is "why this is true". If one were to have retired in 2007, with a major portion of their retirement invested in stocks, their portfolio value dropped significantly, possibly by 50% or more - if one is continuing to invest this is not a problem, you get to take advantage of the average dollar cost over your future investments. However if you are pulling money out of your investments to live on, you cannot easily recover the lost values.

Moving a large portion of those funds to more stable investments minimizes such drastic drops in value.

Answer 2

Presume that you are using the safe withdrawal rate of 4%. So if your retirement account is $1,000,000, you are withdrawing $40,000 a year.

If there is a market correction, and your retirement account loses 33% of it's value, your options are:

• Continue drawing $40,000 a year, which is now 6% of your savings
• Reduce your draw by a third to $26,800

Neither of these is desirable.

On the other hand, it is not expected that if your retirement account gains in value, that your draw will likewise gain; essentially that extra money is just providing a buffer against a correction. So from this point of view, reducing volatility is more important than increasing long term rate of return.

Answer 3

Which would you be more happy with: less money or no money?

The interpretation of the word "risk" in this context is "potential to lose it all", enough reason for anyone to think twice about highly risky investments.

Of course greater risk often brings higher returns, so it's quite literally a game of risk vs. reward.

The deciding factor here is time. Time gives the young the ability to recover from even the harshest of failed investments. If you lose it all at 40, you can still contribute your yearly cap to retirement investments with low risk and have a decent nest egg by 65. If you lose it all at 60, you are, to use the technical term, screwed.

So your best bet is typically, as you say, to make well-informed but riskier investments when you're younger, and then scale down the risk as you approach retirement age. Because having less saved for your retirement is far less unpleasant than having nothing.

Answer 4

Okay, I'm seeing a lot of answers/comments that hinge on sharp downswings and avoiding them (aka, '2008'). That's not the danger of using S&P or similar for your post-retirement holdings. The danger is a long protracted stall of the fund - such as what happened from 2000-2012. When that happens, you're withdrawing $X each year, for 10+ years, but the fund's not replenishing anything at all. Sure, the economy will probably pick up afterwards, but by that point the damage is done: your account is far smaller than what it started with, and the percentage gains have a much tinier effect.

I did the numbers that Victor uses, starting in the year 2000 (though with the slight difference of not including the year's spending money in the index fund - you can't exactly make interest on stuff you've spent or are about to spend.)

Result? The account is down 50% in 7 years. It was down to $246k by the end of 2011. And sure, the S&P kicked back into gear and started posting double-digit gains... but the problem is, at that point you're pulling 20% of your fund each year. Sure enough, the account is gone by the end of 2018.

(Also, as an aside, you shouldn't figure 7% annual averages from S&P. The average from 2000-2018 is 3.8%.)

That's why it's considered high-risk. You might be fortunate, and the S&P doesn't enter any prolonged stalls in the beginning of your retirement - and your fund might last far longer than if it was in lower-risk accounts. But, you might be unfortunate, and retire just as the economy stalls. And if that happens, your retirement account will deplete much faster.

As to the original question?

I'm not sure anyone advises putting all your retirement money into low-risk accounts. If it helps, think of it this way:

I'm retiring now, with $X in my account. I want to plan on living 30 years. So out of all the money I spend, 1/3 of it will be within 10 years - aka, stuff that needs to be very very stable. Another 1/3 of it will be 10 years down the road - aka, stuff that a temporary market downswing doesn't hurt too much, but a stall will. Another 1/3 of it is 20+ years down the road - aka, stuff that I should still keep in a long-term growth account.

See? It's not a situation with absolutes. You're still keeping some of the retirement fund in non-low-risk accounts. You're just keeping less of it there.

Answer 5

If 2 different people both retired at age 60 at the start of 2008 with $1,000,000 in capital, and one took all their capital out of the stock market and placed the funds in savings earning 2%p.a., whilst the other kept the entire $1M invested in an S&P500 index fund. So who would be better off today and whose funds are likely to last longer?

Have a look at the spreadsheet below:

Both are taking out $50,000 each year for living off. The one that puts their savings in savings at 2% will run out of money after 25 years, whilst the one that keeps their money invested in the stock market still has $190,000 left after 25 years.

The returns from age 60 to age 70 are the actual S&P500 annual returns between 2008 and 2018. From then on I have assumed another large fall in 2019 of 35% and then from 2020 to 2033 I have assumed the average annual return for the S&P500 of 7%p.a. This is probably a bit conservative because usually after a large fall there are some years straight after of larger than normal annual gains. So in real life it is likely that the second person would have more than $190,000 left at age 85.

This proves that safety is not always the best option, you make the decision yourself.

Answer 6

Actually, finance theory doesn't suggest a general relationship between one's age or proximity to retirement and the riskiness of one's portfolio. According to modern portfolio theory, the riskiness of your portfolio should be related (only) to your risk aversion/apetite.

The "common knowledge" you mention comes from the fact that many people become more risk averse as they age, either because they rationally fear not having enough money to last to the end of their lives, or simply because their personality changes in their old age.

However, as you point out, there could be a large amount of time between retirement and death so retirement is not a good target date. Moreover, people's preferences and wealth differ. A wealthy person who is not worried about having enough to live on but would like to maximize the expected amount they leave to their heirs, for example, would likely want to increase their risk as they age.

Bottom line: "Common knowledge" only applies to some people. You should let your risk aversion dictate the riskiness of your portfolio, irrespective of your stage in life.

Answer 7

It's not so much that younger people have longer to ride out market swings, it is that they are continuing to save.

If a thirty year old loses a third of their savings, it's bad, but not only with that third most likely recover, but also it is not the whole of their retirement savings - their best earning (and hopefully saving) years are ahead of them.

Answer 8

For decades, the general rule was an allocation ratio of 100 minus your age for equities which decreased your market exposure as you grew older. The remaining portion was placed in safer assets such as investment grade bonds.

Until last year (an anomaly?), life expectancy has been increasing. Coupled with historic lows interest rates, many have questioned whether this rule is still practical. Some investment advisers are now recommending using 110 and even 120 instead of the traditional 100 minus your age so that along with longevity, we have additional years of portfolio growth.

It really isn't this simple because there are other factors to consider: size of retirement portfolio, other sources of income, lifestyle and expenses, even gender.

Despite what I have written, I don't follow this at all. After many years of margin trading, I'm now far more risk averse and I am at a much lower equity exposure than 100 minus my age because I am confident that my assets will last and keeping them is far more important to me than making it - though I don't object to making it. So AFAIC, the short answer is that it depends on your individual circumstances.

Answer 9

UK based answer: Until recently, on retirement you were forced to buy an annuity with your pension pot by age 75 (ref: saga website). This meant that if the market dipped just before you were about to buy your annuity, and didn't recover before you turned 75, you were forced to buy an annuity with a much reduced pot.

The rules have now changed. You don't have to buy an annuity with your pot, and if you do decide to there is no longer an age limit.

The advice for people approaching retirement age to de-risk is therefore now less important than it used to be. But not unimportant (see other answers).

Answer 10

I think I got some interesting results with Monte Carlo simulations.

TL;DR: Balance your portfolio.

Many people answering this question worrying about a big drop right after retirement, mentioning 2008. So I ran my simulation like that.

• Initial amount: 1,000,000 USD
• Withdrawal amount: 45,000 USD / year (inflation adjusted each year)
• Start year: 2007
• End year: 2017
• Rebalancing annually

Here are some results.

• US Large Cap 100%: Link
• Total US Bond Market 100%: Link
• 50%/50%: Link

It seems many answers are concerning sudden drops right after retirement. But this may misdirect many people to go safe investments(like bonds) all the way. I think retirement fund should be seen in the long term, rather than focusing on recent one big drop.

Look at the charts I showed you. I believe retirement funds should last at least 30 years, and the 50%/50% portfolio has the highest success rate. Possibly you can tweak more to get better outcomes, but you get the idea. Unbalanced portfolios are not good for the long-term, hence not good for retirement portfolios. Research yourself for the better options, but don't waste your time tweaking too little things.

Edit 1: As @Pace said, Monte Carlo simulation has its flaws. So I tried backtesting this time(Link). The basic setup is somewhat similar:

• Initial amount: 1,000,000 USD
• Withdrawal amount: 45,000 USD / year (inflation adjusted each year)
• Start year: 2007
• End year: 2018
• Rebalancing annually

In the result, Portfolio Growth (inflation adjusted) graph shows 100% bond portfolio's value is gradually decreasing during the period, faster every year. The other portfolios definitely took the loss during 2008 but recovered afterward. Although the loss is huge, if retirement portfolio last at least 30 years, this is not the major issue.

Here is another test(Link).

This time, I used Long Term treasury instead of Total US Bond Market. Interestingly, in the recovery period, both US Large Cap 100% and 50%/50% portfolios are increasing almost in parallel. 50%/50% portfolio also has highest Sharpe ratio and Sortino ratio too.

While backtesting also has flaws, my point still stands. Balanced portfolios will perform well in both good and bad times. In the long-term, of course.

Edit 2: If we change backtests' start year to 2000 as @kevin suggested in another post(Link), Total US Bond Market 100% is the all-time highest.

You see, that's why I don't like backtesting. It's useful for a certain case study, but it makes hard to generalize strategizes. It makes us very biased. Also, nobody knows what will happen in the future. Focusing on a case might not be a good idea for a long run. Be mindful when backtesting.

BTW, we can change our strategy when our situation is changed. 30 years is a long time. Be flexible. It's your money after all.

Edit 3: Let's try Monte Carlo tests starting 2000 this time(US Large Cap 100%(Link), Total US Bond Market 100%(Link), 50%/50%(Link)). Total US Bond Market 100% has the highest success rate for 30 years. But be careful. If you are expecting your retirement portfolio last more than that(like 35, 40 years), you will get very different results. you can check this from the links' Portfolio Success graphs.

• US Large Cap 100%'s success rate starts dropping early on compared to the others. But the success rate is relatively high in the late years.

• Total US Bond Market 100% is doing very good for 30 years. But after that, all scenarios are starting failing rapidly. Maybe you can prevent this by changing to Long Term Treasury, but that will lose its risk-averse purpose; 50%/50% portfolio with Long Term Treasury has a less standard deviation in this case.

• 50%/50% doesn't look better for 30 years since Total US Bond Market 100% is doing well. But after that, its success rate basically remains the best.

Answer 11

The assumed goal behind the recommendation is that you don't want to run out of money before you die. If you want to leave money for heirs or maximize your retirement income that changes the goal and recommendations. Generally 4% withdrawal is considered "safe" based on the trinity study from the late 90s. If your investments simply keep up with inflation you have 25 years at 4%. So you don't need to make a high percentage on your money in order, but you do need to avoid loosing your investment.

The first couple of years of retirement are far and away the most risky for retirement. If you retired in 2007 with 1 million and planned on withdrawing 4%, if the market drops 50% like it did in 2008, now to maintain your lifestyle you withdraw 40k of 500k a full 8% of your savings. Very few market scenarios would allow you to recover from this situation short of going back to work or dramatically cutting your lifestyle. If however you only have 40% in equities suddenly you have 800k and a a much better chance to recover.

I am not sure the advice is as helpful if you have some mitigation strategies in place for the first few years. Either going back to work part time or cutting expenses dramatically can lessen the impact of the loss significantly.

Answer 12

The short version is this:

The common practice you speak of is built on the premise you will be withdrawing principal and depleting the fund in retirement.

You move to less risk, lower reward funds because you are no longer contributing to their growth. If you saved correctly, you don't need them to grow, you need them to last. The last thing you want is for a swing in the market to take an unexpected chunk out of your principal. You can more safely budget your withdrawals if there is a much lower risk of a force outside your withdrawals taking money out of the fund.

Also, you need it to last FOR YOU. If you want something to be left in the fund after you die, you would need to find that balance of risk and return outside of this general practice, which is intended to prevent losses, rather than make gains.

Answer 13

Most people of retirement age have decided money in excess of their basic needs does not make them happier. A Florida trailer park and a public beach are just fine, but but going back to work after being out of the job market for a decade is not an option.

So there's some amount of income which is "enough", and the objective is to find the cheapest portfolio which is almost certain to last until death. Let's say "almost certain" means there's a 5% chance of being wrong.

Consider a hypothetical conservative portfolio, with an expected mean annual return of 4%. In any given decade the returns may be more or less, but in 95% of the decades the annualized return is at least 3%.

A more aggressive portfolio may have a mean return of 8%, and in 95% of decades the return is at least 1%.

For retirement planning, it's not the mean return (4% vs. 8%) that matters, but the "worst case" return (3% vs 1%). If the objective is to have a portfolio that is 90% likely to not run dry, the conservative portfolio is cheaper.

As the time horizon broadens the worst case become less bad, but the horizon must be very broad, several decades, before an aggressive portfolio's worst case is better than a conservative worst case. Risk comes not only from sharp market crashes, but also protracted periods of poor performance. Consider the Nikkei 225 index (Japan), which hit a high at the end of 1989, and has been up and down within the same band several times since.

One must be very young for such a broad horizon to exist.

Answer 14

In addition to the consideration of risk related to age, there is another, related, consideration. Risk has been discussed in many other answers already.

As you retire, it is important to shift from growth to income-producing investments. This is easiest explained by example of somebody who chooses to invest in real estate for his retirement security. For somebody in his 30s and 40s, it makes a lot of sense to buy houses, or build them, even if you have to take out a mortgage for it. You are building your wealth here. When you are in your 70s, you want to have a consolidated portfolio that gives you regular income from rent checks. You are not using your wealth, but rather you are reaping the fruit of it. And if you have enough buildings, on occasion you can sell of one to splurge on something in retirement.

At first glance, it may appear that stocks are different because they are passive rather than active investments. But they really aren't all that different. During your 30s and 40s, you'd buy growth-oriented stocks, even some high-risk stocks (like Yahoo, Pets.com or Google in the dotcom era, or Tesla, Uber etc. today), and hope that they have matured into solid businesses by the time you reach 65.

Of course, some people (or their funds) trade stocks much more actively, but that doesn't necessarily produce better results.

Personally, my favorite investment when you retire? Pay off your mortgage. Even if you have to sell off most of your 401(k). Paying off your mortgage gives you a guaranteed return of 4% or more depending on your interest rate, in the form of interest-free and rent-free living, for the rest of your life.

Answer 15

Actually it's true for everyone, the 'common knowledge' is wrong. The best strategy, for all ages is 90% in some inflation hedged cash equivalent, and 10% in ultra volatile very high risk, but potential high reward investments. This is called the barbell strategy. See the works by Nassim Taleb explaining this. The main books where this is explained from an investment perspective are "Fooled by randomness" and "The Black Swan".

Don't believe this? See this article which also shows that, even over very long periods, just switching your money between the best savings accounts available can beat the stock market, but with no risk to your capital. This doesn't discuss the barbell strategy, but does show that the excess returns from the stock market over virtually any period less than about 20 years do not actually exist because of occasional big falls, and there is a risk that at any particular time, you could be unable to withdraw your capital because you have to wait 10 years for the market to bounce back from a big fall. From the article:

Savings accounts beat the total returns on the tracker in 57% of the 192 five-year investment periods beginning each month from 1 January 1995 to the present. The tracker won in just 43% of periods.

Looking at longer time periods, the results were even more marked. For example, over the 84 14-year periods from 1995, cash beat shares a whopping 96% of the time.

Looking at a range of investment periods since 1995, from one to 11 years, the analysis found investments in funds that track the FTSE 100 would have actually lost money up to a third of the time. By comparison, there's no risk if you put cash into a savings account – you always end up with more than you started with.

The other part of the strategy which is to invest 10% in more risky things would involve things like out-of-the money put options, or things like an unlisted business with high potential for growth etc. There's no easy answer to this part unfortunately.

Note this answer has been been downvoted, but no-one has actually refuted my points.

Answer 16

The common wisdom is very wrong.

People used to retire at age 65 with a pension from a large company and some savings. 50 years ago, if you lived to 65, your expected lifespan was less than 5 years. Today if you live to 65 in the U.S., your expected lifespan is to the mid-80's. And, of course, some people will live longer. So you need to plan to age 95 to be safe.

Today, few people have a pension - they have their own savings, likely in a 401|(k). Let's suppose that is the case. |And let's suppose you have saved $600,000.

The wrong way to think about this is 'let me move it all to bonds and live off the interest'. Why? (1) you would only get, at best, 3% interest. That's only $18,000 per year, and (2) taxes will be very high on bond income.

But its worse. If it is currently in stock you bought long ago, you would need to sell that first to buy bonds. Suppose you have a 25% tax rate; if it is a 401(k) maybe 33%. SO, right away you have reduced your $600,000 to $400,000 to $450,000. At 3%, that pays $12,000 to $13,000 per year.

Really, over the long-run - and 30 years is the long run - the stock market is a better bet. People worry too much (like in the post above) about a recurrence of 2008. But, that is a very rare occurrence. In reality, the market goes up on average about 8-10% annually. And, dividends are about 2% as well. So, $600,000 will pay you about $12,000 in dividends or so per year.

Plus, on average, the stock goes up $48,000 to $60,000 per year on top of that. So you can spend some of those profits as well (which, like dividends, will be taxed at 15%, or 20% at most - unless in a 401(k). Even if markets are anemic, or you are conservative, you can spend likely $30,000 plus the $12,000 of dividends - $42,000 - and at that rate the account would keep going up in value as well.

People worry way, way too much about a market meltdown. If you have 30 years to plan for, you will live through one or two. But unless you have so little money that a 25% drop in a single year that recovers over the next 4 years (sort of what happened), stocks are a much better investment.

Here is a great old rule. Whatever percent you ear, divide 72 by that number and that is how long it takes to double your money. Even if you get 7%, in 10 years your account doubles. If that happens, and a 30% market drop happens, you are still way ahead.

People focus way too much on the short-run and buy things like bonds. In many cases the only certainty they get, if they knew how to calculate it, is a certainty of going bankrupt before dying.