Should you only invest in shares in retirement?
The risks and opportunities of a portfolio heavily weighted to shares in retirement.
Last week I explored a topic that investors constantly bring up. If over the long-term shares outperform bonds, does it make sense for a long-term investor to just invest in shares. In the first article I explored the justification for an investor that is still employed to take this approach.
There are some behavioural pitfalls to avoid but if an investor has their financial house in order with an adequate emergency fund and low levels of debt this might be a rational approach to pursue.
This week I will tackle retirees. And once again this is far from an academic exercise as there is amble evidence from my own conversations and accounts in the press that retirees are taking this approach.
Asset allocation is highly personal, but the industry view is that investors should be on a glide path as they approach and enter retirement. During this stage allocations to defensive assets including bonds increase and allocations to growth assets including shares decrease.
Conventional wisdom used to state that an investor should take 100 minus their age to determine how much should be allocated to shares with the remainder in bonds. This rule of 100 was later changed to the rule of 110 to account for longer life spans. I’m not a big fan of conventional wisdom but it is safe to say that keeping most of your portfolio in shares during retirement flies in the face of traditional and current advice.
Checklist for an all-equity portfolio
- Have the right temperament to hold for the long-term and resist over trading
- Understand the implications of the decision and get your financial house in order
- Widely diversify
- Consider a focus on income
- Using cash to mitigate risk during and after the transition to retirement
Retirement is a milestone but not a destination for a portfolio
Retirement is clearly one of life’s major milestones. Even if there are differences between reality and perception. The popular portrayal of retirement involves a dramatic transition. One day you wake up and head to work. The next day you are left to your own devices. This transition is facilitated by an investor hitting their retirement goal. This goal involves amassing a sufficient account balance to support them for the rest of their life. Some pre-retirees are fixated on their walking away number or the amount of money needed to finally quit working.
In reality the transition to retirement is a bit more nuanced. Many people transition to retirement slowly by working part-time or shifting the focus of their employment to something more aligned with their interests. Many people don’t get to choose when they retire. Job loss or not physically being able to keep working may be the driver of retirement.
The idea that a certain account balance is the driver of retirement is also a bit of a misnomer. Estimating how much is needed for retirement is a valuable exercise and one I outlined in this article. At the same time a portfolio is a living and breathing entity and the act of retiring does not freeze a portfolio in place or dramatically alter asset allocation on a single day.
From an investment perspective the act of retirement does not suddenly change the investment time horizon of an investor. Retirements can last decades. And it does not change the person that is retiring. A retiree who built a comfortable nest egg by successfully investing in shares for decades is unlikely to think the act of retiring is a good justification to switch to completely different strategy.
Our experiences guide our actions. People coming of age in the great depression famously sat out the share market even decades later due to the formative experience of watching the market plummet. Current retirees have had the opposite experience. Surging share markets during current retirees’ lifetimes have no doubt left an indelible impression of the relationship between risk and reward and the pathway to investment success. It is not surprising that many retirees have portfolios heavily weighted towards shares.
Does the way investors access bonds match our perception of bonds?
Any examination of the risk of a portfolio heavily tilted towards shares needs to explore the alternative option for retirees. And that alternative is bonds. I will explore how shares and bonds address the major risks facing retirees but first there are some misconceptions to correct on investing in bonds.
Many investors view bonds in an antiquated way. Our notion of fixed interest investing is often based on the fact of buying individual bonds. Buying an individual bond with little chance of default like an Australian government bond or AAA rated corporate bond is different than buying a bond ETF or fund.
If I purchase $1000 of a 10-year Australian government bond at par with a 5% interest rate I’m reasonably certain of a couple things. If the Australian government does not default I will receive $1000 back in 10 years. I will receive interest payments totalling 5% a year which means I will earn a 5% annual rate of return over 10 years.
Purchasing bonds through an ETF or a fund is different. There is no maturity. There is no set rate of return that is guaranteed. The prices of the ever-changing portfolio held by the ETF or fund matter. Converting my investment to cash does not mean waiting for maturity. It means making a conscious decision to sell my position. A decision that may be dictated by cash needs in retirement.
Investing in a bond ETF or fund means that investing in bonds isn’t straightforward anymore. The direction of interest rates over a holding period will matter. Changes in the shape of the yield curve or the interest rate for bonds with different maturities will matter. The spread for the bonds in the portfolio over the risk-free rate or how investors are currently assessing default risk matters.
This doesn’t make a bond ETF or fund bad or good. It makes them different. This next statement is a bit controversial. But the way that individual investors bought bonds historically involved no actual volatility. That is because the focus was buying safe bonds and holding them to maturity while collecting a set interest rate over the life of a bond.
I believe a lot of individual investors still have that expectation that bonds are safe because they are picturing purchasing an individual bond. This presents a challenge because there is a mismatch between perception and reality. That mismatch between expectations and reality can cause issues even if the inherent volatility of bonds should not change long-term investing decisions.
The risk of volatility in retirement
In the first article I explored the notion that while volatility doesn’t really matter for most long-term investors it does often lead to poor decision making. For retirees the impact of volatility is more nuanced. Volatility can matter a great deal if you are selling assets off in a down market. That leaves less of an asset base to take advantage of a recovery in markets. This is known as sequencing risk and matters for retirees because assets are typically sold each year to support day to day living expenses.
On the surface volatility is a big problem for a retiree with a portfolio heavily or completely invested in the share market. Shares have more volatility than bonds. Simply adding bonds to a portfolio will therefore lower the volatility of the overall portfolio.
Bonds are still volatile. Investing in a laddered bond portfolio of individual bonds that mature at different times to partially fund withdrawals is one way to effectively remove the impact of volatility of investing in bonds. Investing in bond funds or ETFs does not remove volatility from a portfolio. In theory if bond yields keep increasing a bond fund or ETF will lose money each and every year.
There are a couple different roads a retiree can go down to limit the risk presented by volatility in a portfolio heavily weighted towards shares. One approach is to simply construct a portfolio of shares with lower volatility. Some sectors have lower volatility than others. Healthcare, Utilities and Consumer Defensive shares are typically less volatile than cyclical shares like Energy or Basica materials. There are some attributes of shares that also decrease volatility such as shares that pay dividends or large companies as compared to non-dividend payers and small companies.
Another approach to limiting the impacts of volatility is to live off the income generated by dividend paying shares. This is a strategy that many retirees take advantage of given the high dividend yields in the Australian market. I’ve written about this approach in my article Can you retire on dividends. The advantage of living off income or simply having a portfolio that generates a high level of income is that assets don’t need to be sold during poor market conditions.
Finally, there is cash. Unlike bond ETFs and funds cash has no volatility. Cash can be used to blunt the impacts of volatility by funding withdrawals without having to sell assets until markets have recovered. This is the theory behind the bucket method to portfolio allocation and it is also the approach I take with my mother’s portfolio. She is nearly a decade into retirement with a portfolio that consists of cash and shares. For more on the bucket approach you can listen to our podcast episode of Investing Compass.
Inflation is another risk in retirement. A common goal of retirees is to create a steady real – or inflation adjusted – standard of living. As the costs of goods and services increase over time the amount withdrawn from a retirement portfolio increase to keep a steady standard of living.
Inflation can have a particularly corrosive effect on retirees. Retirees typically have high levels of assets which can erode in value during inflationary times while not earning a wage that can be adjusted to reflect higher prices.
There is a strong case for holding more shares to mitigate the risk of inflation. The returns of almost every asset class are reduced in high inflationary environments. Yet historically shares have tended to do much better. An article in Firstlinks shows the historic real – or inflation adjusted – returns from different asset classes in different inflationary environments. In high inflation years shares still managed to generate positive real returns. Bond returns were negative in real terms which means that bond investors failed to earn a return that outpaced inflation.
This makes sense. Most bonds have fixed interest payments which become less valuable when inflation increases. Bond investors typically insist on higher bond yields if inflation is expected to persist. The increase in bond yields leads to lower bond prices.
A company may struggle in a higher inflation environment but there is the ability to raise prices and pass all or a portion of the pain onto consumers. This ability to increase revenue and earnings in an inflationary environment helps to protect share prices.
Cash does not fair well in inflationary times but there may be an advantage to cash over bonds as interest rate increases are passed onto existing holders of cash instead of simply reducing the value of existing bond portfolios in bond fund and ETFs.
According to Vanguard’s 2023 Index Chart Australian Government bonds have delivered annual returns that exceeded inflation by 2.8% over the last 30 years. Cash has delivered returns in excess of inflation by 1.5% over the same time period. It should not be underestimated how big of a difference 1.3% a year makes over the long-term.
However, each retiree needs to determine if the inherent advantages of holding cash with zero volatility outweighs the excess returns available through government bonds with some volatility. Given the volatility differential a portfolio made up of shares and one other asset class would require less cash than bonds to reach the same level of overall volatility.
The ability to reduce overall portfolio volatility to the same degree holding lower levels of cash than bonds and my fear that bond returns will continue to be weak in the future as summarised by my colleague James’ in a recent article makes my decision easy. I’ve chosen to simply hold cash in my mother’s portfolio.
The challenge of retirement planning is the end date is unknown. People have different lifespans and living a long time makes it more likely that a retiree will run out of money. Running out of money is the biggest risk for any retiree.
To guard against an especially long retirement it is important to not get too conservative and stay invested in growth assets. This is a case for more of a weighting to shares. Once again, the risk of selling after a portfolio has had a significant drawdown will have to managed.
Should you invest in only shares in retirement?
Possibly. Taking such an unconventional approach should not be done lightly. There are significant risks that must be mitigated regardless of the approach taken during retirement. I’ve offered some ideas on how these risks can be addressed but the biggest risk is complacency about how far a share portfolio can fall in a bear market.
A 50% drawdown is not unheard of in previous bear markets. The NASDAQ dropped almost 80% during the .com bust. Returns and portfolio resilience should be balanced. Investing is all about trade-offs and understanding the risks faced by retirees provides some context to those decisions.