Historically, stocks have earned significantly higher returns than less volatile investments like bonds, cash, and CDs. And that makes sense–their higher volatility should be compensated in the form of higher expected returns.
What I find particularly interesting is that, despite the additional expected return that stocks get you, they don’t really allow you to (safely) increase your retirement spending by very much–at least not in the early part of retirement.
“Safe” Withdrawal Rates
The withdrawal rate figure most often suggested for a 30-year retirement using a typical stock/bond portfolio is 4%. That 4% withdrawal rate isn’t exactly bulletproof though. For example, as researcher Wade Pfau recently explained, while the 4% rule has worked reasonably well in the U.S., it’s had significantly worse results in other developed economies:
“In the years since 1926 and for a 50/50 asset allocation, the 4% rule would have failed retirees in 10 of the 17 developed countries more than 25% of the time. Remarkably, the 4% rule would have failed more than 70% of the time in Spain and Italy.”
In contrast, consider a hypothetical, very low-risk portfolio (consisting primarily of TIPS, with some short-term Treasuries and CDs thrown in the mix). If that portfolio can earn a zero percent real return every year (that is, it matches inflation but never surpasses it), it would safely fund a 3.33% inflation-adjusted withdrawal rate over 30 years (because 100% ÷ 30 years = 3.33%).
That’s only 0.66% lower than the not-entirely-safe 4% withdrawal rate from a portfolio that allocates a significant amount to stocks.
What About Annuitizing?
If we throw a lifetime annuity into the mix of the low-risk portfolio, the gap gets even smaller. Based on Vanguard’s quote provider, even with today’s low interest rates, a married couple (both age 65) could get a single premium immediate lifetime annuity (with inflation adjustments and a 100% payout for the surviving spouse) with a payout of 4.25%.
If we assume half the portfolio is allocated to such an annuity and half is allocated to the other low-risk investments discussed above, that would allow for a withdrawal rate of 3.79% (the average of 4.25% and 3.33%). That’s pretty darned close to 4%, and we haven’t allocated a dime to stocks or other high-risk investments.
So Why Would Anyone Own Stocks in Retirement?
While allocating a part of your retirement portfolio to stocks doesn’t dramatically increase the amount you can spend each year at the beginning of retirement, it does get you two things:
- The possibility of higher spending in the later stages of retirement, and
- The possibility of leaving a big pile of money to your heirs.
For example, with a significant portion of your portfolio allocated to stocks, you might find that after 15 years of retirement, your portfolio has actually grown in inflation-adjusted value to twice its original size (something that just wouldn’t happen with a portfolio comprised exclusively of super-low-risk investments).
At that point, with 15 fewer years remaining and a larger portfolio than you started with, you can probably safely increase the rate at which you’re spending. Alternatively, you could keep your rate of spending the same in order to leave a large inheritance to your kids or other loved ones.
In other words, the compensation for taking on risk by including stocks in your retirement portfolio isn’t that you automatically get to spend a great deal more from the outset of retirement. The compensation is that you might get to spend a great deal more during the later stages of retirement.