Nobel laureate Bill Sharpe has said that knowing what to do with your money after you retire is “finance’s worst and most difficult problem.”
It got even harder for weeks like this, turning out to be the worst on Wall Street in years. It reminded investors that putting money on the stock market is not a sure thing. That’s bad news if you’re about to retire and plan to spend your savings. Will the current correction turn into a real bear market? It is always a possibility. If you are about to retire, it is worth asking yourself: should you take all your money out of the stock market?
It depends, of course.
You probably can’t afford to avoid stocks
The stock market can be risky, but with that risk comes higher expected returns. You can eliminate the risk by placing money in bonds or by purchasing an annuity. Based on Federal Reserve data, the average American over 60 in 2016 had $ 180,000 in their retirement account, which works out to about $ 8,600 in income per year.
Since most people haven’t saved enough to retire safely, the average retiree’s investment portfolio is 40% equities just before, after, and well after retirement.
You probably have a target date fund
Instead of whether you should be in or out of stocks, a better question to ask is how much of your retirement savings should be on the stock market. You probably need to take risks to increase your chances of increasing your wealth, but it’s also prudent to hedge and put money in low-risk assets so that you don’t have to bear the brunt. of all the volatility if it hits at an inopportune time, like retirement.
According to estimates from the Investment Company Institute, approximately 20% of the assets of employer-sponsored retirement accounts in the United States are invested in a target date fund. (Almost 70% of target date fund assets come from company sponsored retirement accounts.) A target date fund shifts portfolios to bonds and stocks as the owner nears retirement. The idea is that there is a perfect balance between stocks (risky) and bonds (safe) – for the argument, let’s say it’s 40% stocks and 60% bonds.
As you get older, your future work income, which looks like bonds, is a smaller share of your overall wealth. Young people tend to have virtually no savings and many years of future income ahead of them, so their “portfolios” – current and future savings plus income – are over 90% invested in bond-like assets. . This is too much, many will say, so most target date funds are set up to invest almost all of a young person’s savings in stocks.
As future profits decrease relative to savings, you need to buy bonds to maintain a 40% ratio. That’s why target date funds turn into bonds as owners get older. And then, one day, you’ll retire, and future earnings from work will drop to zero. Since target funds gradually build up bond holdings over time, retirement is not a reason to suddenly sell all of the stocks you own. That is, unless you can’t take the risk, in which case you shouldn’t be in stocks in the first place.
According to Morningstar, the average target date fund is around 40% in equities when people reach retirement. They tend to keep the split around this share throughout retirement. But just because that’s what target date funds do that 40% of stocks are right for you.
How many do you need?
How much you should put your post-retirement savings in stocks depends on the answers to a few different questions:
1️⃣ How many risks can you tolerate? The less you can stand, the lower your equity allocation should be.
2️⃣ What are your spending needs? Cautious advice suggests funding your daily necessities and medical expenses with safe assets, like bonds or an annuity, and using the money in your stock portfolio for discretionary things like travel.
3️⃣ Are you well funded? If you’ve saved enough before you retire, safe bond investments or an annuity can cover the expenses, so you may not need to take any risk on stocks. Or if you have a stable source of income in retirement, such as a defined benefit pension, annuity, or part-time income, you can afford to take more risk because your wealth already includes a bond-like asset.
The recent stock market turmoil reminds us that the stock market offers no guarantees. Whether or not you’re nearing retirement soon, it’s wise to establish a risk strategy that strikes the right balance between stocks and bonds, and stick to it while the markets do what they do.
Correction: A previous version of this article indicated that 68% of the assets of employer-sponsored retirement accounts in the United States are invested in a target date fund. It should represent 20% of the assets of these accounts; 68% of target date fund assets come from company sponsored retirement accounts.