Rethinking retirement savings

There’s a well-known script for how to manage your retirement nest egg: start saving early in your career, put as much as you can into tax-advantaged accounts, and increase the portion of your portfolio devoted to bonds as retirement approaches. Then withdraw 4 percent in the year after you stop working and adjust the amount annually for inflation.

But this playbook has come under increased scrutiny lately. Some experts are challenging the conventional wisdom on how you should save for retirement and how you should manage withdrawals once you stop working.

What’s different today? The stock market has ascended to new heights, while bonds now offer low yields. Healthcare costs are rising rapidly. And people are living longer, which means retirement could last 30 years; and many people have a younger spouse whom the portfolio needs to support even longer than that, says Aaron Anderson, senior vice president of research at Fisher Investments in San Francisco. All of this has shifted the calculus for retirees.

Another factor is the Consumer Price Index, which measures inflation in the U.S. but “doesn’t tell the whole story for someone in retirement,” says Anderson. The CPI incorporates categories where retirees may not be buying as heavily as younger consumers, such as cars and electronics, which have seen price drops. (The measure also doesn’t include college tuition, an increasingly large expense for many Americans, but one that isn’t likely to be a factor for many retirees.)

Moreover, with recent inflation at an annual rate of around 2 percent—about the yield of medium-term Treasury bonds—retirees’ money may have less buying power than they think over time, says Heather Loomis Tighe, a managing director at BlackRock in San Francisco who heads the Institutional Endowments, Foundations, and Family Office business for the West Coast and western Canada.

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Given all of these factors, the “4 percent rule” for withdrawals during retirement may no longer be the best strategy, she says. “I would say scale that back,” advises Tighe, who cites healthcare costs as one major category of spending that may require more of retirees’ savings than planned. (It should be noted, though, that many retirees keep their savings in tax-deferred accounts that have required annual minimum withdrawals, so they may not have the option to take out less than about 4 percent. They can still, of course, choose to spend less than that amount.)

It can also make sense not to receive Social Security until age 70, because waiting results in higher payments, says David Littell, a professor in the retirement income program at the American College of Financial Services in Bryn Mawr, Pennsylvania. Deferring retirement account withdrawals until they’re required is also a good idea because it allows the money to remain tax-sheltered for as long as possible. (For traditional IRAs, the required first withdrawal date is April 1 of the year following the year when you turn 70½; for 401(k)s, it’s generally that date or April 1 of the year after you retire, whichever is later.)

Using taxable accounts to fund living expenses for the first few years of retirement can keep you in a lower tax bracket than would apply if you started withdrawing the sheltered funds, Littell says. He also recommends moving money to a Roth IRA for as long as possible: even if you’re largely retired, you or your spouse might do consulting or other part-time work; and you’re allowed to put up to $6,500 per person in a Roth IRA each year, as long as you’re earning that much in income.

Another element of the typical retirement plan is asset allocation that skews heavily, or entirely, toward bonds once the investor has reached retirement age. That may be misguided, some research now suggests. Littell says that Wade Pfau—also a professor at the American College of Financial Services—has concluded that savers should reduce their equities allocation to 30 percent of their portfolio at retirement, and then begin increasing it to an eventual 70 percent.

Raising the percentage of your nest egg that’s in stocks may seem like a dangerous thing to do in retirement. But diversifying your portfolio by adding different geographical regions and asset classes can reduce volatility. If your stocks fall, you may want to rely on cash or other funds to pay expenses rather than selling devalued shares.

“If you start taking money out, and the market goes down, you’ll deplete your funds,” Littell says, adding that some investors also buy put options to protect themselves if their stocks lose value.

As the bond market sputters and stocks soar, retirement savers and retirees are finding it tough to get guaranteed income that beats inflation, says Karan Sood, CEO of CBOE Vest, the asset-management arm of the Chicago Board of Exchange, based in McLean, Virginia.

“Bond yields are really low and they’re likely to go higher, so that’s a really big dilemma for income seekers,” Sood says. “The traditional space that was always delivering income with a high level of certainty is now challenged.”

As retirees look for yield elsewhere, they’re heading into riskier assets like dividend-paying stocks, preferred stocks, high-yield bonds, REITs, and MLPs, he adds.

Many of Sood’s clients buy CBOE Vest mutual funds that use options to limit the amount of money they can lose on stocks; they’re essentially paying for insurance by giving up some of the potential appreciation. These funds have fees of about 1.25 percent of assets, or 0.7 percent in a retirement account. Selling options on the upside means retirees can get 6 to 7 percent annual return from the funds, although they don’t get to keep any appreciation above that level, Sood says.

“With those kinds of returns in mind, you can give up some of the extreme returns in the stock market, and you don’t have to pay for the protection out of your pocket,” he adds.

It’s often a mistake to shift entirely to fixed income when you stop working as a way to decrease risk, Anderson says: “We would argue that people still need a lot of growth in retirement.”

Retirees may also want to rethink moving their money into alternative investments like hedge funds and private equity funds because they offer limited liquidity, Anderson notes. Although these funds may hold out the promise of higher payouts in the future, it’s crucial to understand when that money will be paid out.

“For most retail investors, getting access to their money when they need it is critical,” Anderson says.