Imagine this situation: A married couple has one spouse who is a stay-at-home parent (who generates no income). The income-generating spouse dies at age 30, with an appropriately-sized life insurance policy. How should the surviving spouse invest the life insurance proceeds?
It’s a tricky question, and I don’t have a perfect answer. (I’m not sure there is one.) Still, I think that anyone who could potentially find himself/herself in such a situation would be wise to make a plan ahead of time.
It’s akin to planning a super-long retirement. We have to determine how to invest a portfolio from which you want to take a stream of inflation-adjusted withdrawals over a very lengthy period (potentially more than 50 years).
- What asset allocation would you use?
- What rate of withdrawal would you be comfortable using?
A part of what makes these questions so difficult to answer is the fact that we can’t learn much from backtesting various asset allocation/withdrawal rate combinations to see how they’d hold up over historical 50-year distribution phases. After all, we only have two such independent 50-year data sets–not exactly a large sample size.
On the one hand, for such a lengthy period, it seems that it would be difficult to achieve the long-term returns necessary to sustain 50+ years of withdrawals without a hefty stock allocation.
On the other hand, the “sequence of returns risk” problem that plagues retirement planning becomes even worse when we’re looking at such a long period. If the investor uses a stock-heavy allocation and the first few years go particularly badly, the portfolio could easily fail to generate the desired income for another 50+ years.
Personally, I’d attempt to minimize sequence of returns risk by using a fairly conservative allocation–something like 40% stock, 60% bond (with a healthy portion of the bond allocation being invested in TIPS). But I’d only be comfortable using such a conservative allocation because I’d also make sure to…
Use a Low Withdrawal Rate.
The most important piece of the puzzle is to use a very low starting withdrawal rate (3% or lower). The goal is for the portfolio to last almost indefinitely. If you aim for the portfolio to be depleted at the end of the 50-ish-year expected time horizon, but you overestimate the sustainable withdrawal rate by even 1%, you could run out of money far earlier than desired.
What Would You Do?
As I mentioned above, there simply isn’t enough data to get a very conclusive idea of how well any given strategy would have held up historically over 50+ year periods. As such, the above thoughts are what I would do with the money, but I absolutely cannot say that there would be no better approach.
What would be your plan if you were faced with the prospect of having to draw from a portfolio for (potentially) more than five decades?