MONEY retirement planning

Plan for the Critical First Decade of Retirement

Michael Kitces, 36, partner and director of research, Pinnacle Advisory, argues that to safeguard your retirement savings, start with a small stake in stocks and gradually increase your equity holdings. © M. Cody Pickens Photography 2013

If you invest too cautiously, your money may not grow fast enough. Adding more stocks as you age may actually reduce the risk of running out.

Choppy markets and rising health care costs needn’t stop you from having the money for the retirement you want. We asked five of the brightest minds in retirement planning for their big ideas to help you cruise through the obstacles.

Below advice from our fourth expert, financial planner Michael Kitces.

Big idea: Protect your critical first decade

Michael Kitces has taken a well-established idea in planning and followed it to a surprising, even wild-sounding, conclusion about what it means for your investing.

The idea is called sequence risk: After you retire and start drawing on your savings, it’s not just the long-term average rate of return that matters.

The order in which those returns arrive is crucial. Retire near the start of a bear market or even just a long period of mediocre returns, and the effect of withdrawing dollars from a shrinking or stagnant portfolio is that you won’t have as much to gain from a rebound. Take a person with a 5% initial withdrawal rate who retired in 1971, just in time to catch the nasty 1973-74 bear, ran out of cash in 24 years. (That’s the reason planners say 5% is too high.) Then take the same set of annual returns and reverse the order so that the first 10 years are good, and in 24 years there is still 50% more money than in year one.

The obvious lesson is to be conservative when you retire — but if you are too safety-conscious, it will be harder to make your money grow fast enough to last for a long retirement. Most financial planners — as well as target-date mutual funds aimed at retirees — approach this by putting investors in a moderate amount of stocks at 65 and then reducing that stake each year.

Here’s the surprise: Kitces, in a paper he wrote with Wade Pfau, argues that you can protect more savings by starting with a smaller stake in stocks and then gradually increasing your equity exposure. The idea is that if you can get through the early years with your portfolio intact, you can still handle owning stocks later.

In tests of thousands of simulated markets, Kitces and Pfau found that portfolios starting with as little as 20% in stocks and increasing to 60% had a better chance of lasting 30 years than portfolios that began high in stocks and gradually decreased. The portfolios also had less severe shortfalls when they failed.

The differences were not large: A rising-equity portfolio might be a percentage point or two more likely to last 30 years than a traditional approach. What’s compelling is the idea that you don’t have to bear so much risk during the early years. That could protect you from the angst you would experience — and the panicky moves you might make — if you see your hard-earned savings dwindle when you know you still have 25 to 30 more years ahead to pay for.

Reaction to the paper was strong. Finance professor Moshe Milevsky tweeted, “Sure. Why not? Let’s allocate 90-year-old grandma to 90% stocks.”

Kitces says he never recommended such a high stake. Milevsky tells MONEY he was being hyperbolic and agrees that sequence risk is pernicious, but adds, “Probabilities and shortfalls don’t capture all dimensions of risk.”

Kitces says he’s enjoyed sparking a debate. “That’s the inevitable reality of challenging conventional wisdom,” says Kitces.

MAKE THE RIGHT MOVES

Don’t be afraid to drift. It’s one thing to write a paper pinpointing a theoretically optimal strategy. But as Kitces acknowledges, making a plan to increase your market risk as you get older doesn’t sit right in most people’s stomachs.

Keep in mind, though, that if markets do well in your early years, even a small amount in stocks will grow your portfolio. Once that happens, you may feel more comfortable owning more stocks. (If markets don’t do well? You’ll be glad you were conservative.) You don’t even have to pull the buy trigger: Kitces notes that if you simply forgo rebalancing, your equity stake is likely to drift up over time.

You can start with a guaranteed income. Kitces says some fairly popular, conservative retirement strategies actually work as well as they do in part because they create the opportunity to own more stocks later. For example, if you put a portion of your assets into an immediate annuity with a payout that covers your basic expenses, you can allow stocks to take up a larger portion of the portfolio left over as their value increases.

Michael Kitces’s mind, and his thumbs, rarely seem to take a break. He’s a power tweeter with more than 12,000 followers. He also writes a financial planning blog called Nerd’s Eye View. A theater minor in college, he serves on the board of a local improv company. Kitces says his mission is to “shine a light on long-held assumptions” about investment and income strategy.

Click below to see more big ideas from some of the retirement-planning world’s sharpest minds:

Forget the 4% withdrawal rule: Wade Pfau, professor of retirement income, American College

You’ll spend less as you age: David Blanchett, director of research, Morningstar Investment Management

Plan to pay for future health costs: Carolyn McClanahan, president, Life Planning Partners

Social Security is the best deal: Alicia Munnell, professor of management, Boston College

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