Pre-retirees and retirees may understandably worry about their exposure to stock market risk, particularly in these uncertain times.
Let’s see what a hypothetical 65-year-old couple might think of this decision. Suppose Jack and Mary have $400,000 in retirement savings and they are invested in a target date fund with the classic “60/40” asset allocation: 60% invested in stocks and 40% in bonds. . Does a 60/40 asset allocation contain too much risk for them?
Their conclusion could be “yes” if they consider only the dollar amount of their retirement savings when making asset allocation decisions. However, they might think about it differently by reviewing the total amount of all their retirement income. Then, instead of making “asset allocation decisions”, they could make “retirement income allocation decisions”.
An example of a retirement income attribution decision
Suppose that Jack and Mary between them can expect to receive $37,836 a year in Social Security benefits at age 65.
Let’s also assume that when they calculate how much to withdraw from their retirement savings to supplement their Social Security, they use the IRS’ Required Minimum Distribution (RMD) methodology. Even though the RMD is not required until age 72, the same methodology is an achievable retirement income strategy no matter when they retire. According to the RMD method, Jack and Mary’s withdrawal percentage at age 65 is 2.9499%, which gives a withdrawal amount of $11,800 in the first year of their retirement.
Now let’s look at their retirement income allowance. Adding their Social Security income to their annual withdrawal from savings, Jack and Mary’s total annual retirement income is $49,636. Of that total, 76% represents Social Security income, which does not decrease if the stock market crashes and also increases for inflation each year.
The portion of their retirement income that is subject to investment and inflation risk is the amount of $11,800. However, only 60% of this amount is backed by equity investments, with the rest backed by bonds. By multiplying $11,800 by 60%, $7,060 of their retirement income is subject to market risk each year. This amount represents only 14% of their total retirement income.
Consequently, their distribution of retirement income is 14/86, a very different allocation percentage from their 60/40 asset allocation.
What if they use the 4% withdrawal guideline?
If Jack and Mary use a drawdown strategy less conservative than RMD, their retirement income allocation will be different. So suppose they use the 4% rule to determine how much to withdraw from their retirement savings. Applying 4% to $400,000 results in an annual withdrawal of $16,000 from their savings in the first year of retirement. Only 60% of this amount is subject to market risk, or $9,600. This amount represents 19% of their total retirement income.
In this case, their retirement income allocation is 19/81, which is still well below their asset allocation of 60/40.
This example illustrates that the attribution percentage of their retirement income depends on the method they use to generate retirement income from their savings and the amount of retirement savings they need to deploy. To use round numbers, Jack and Mary’s retirement income split could drop to 20/80 or less, depending on their decisions and circumstances. The retirement income allocation percentage paints a very different picture than the asset allocation percentage.
By reviewing their retirement income allocation to take into account all of their retirement income, Jack and Mary can make more informed investment decisions. And, as a result, they might feel more comfortable with the asset allocation of their target maturity fund.