What’s the equity exposure you need in Retirement?

Jan 28, 2021

As the returns on fixed income instruments disappoint those in need of reliable retirement income, the bull run simultaneously (and dangerously) beckons. It is unnerving to see investors actually contemplate going all-in on stocks.

Which brings us to the pertinent question: How much equity exposure must a retiree take?

In general, it's a good idea for retirees to have exposure to stocks. 

If I look at my model portfolios, even the conservative ones have around 40% in equities. The key reason being that retirees absolutely need growth potential.

Retirement for many of us will be a 25- or 30-year or even longer time period. So, you absolutely need to make sure that your portfolio grows, that it beats inflation.

Looking at the yields today, the return potential on safer investments is quite low. Yields are quite neatly correlated with future returns over the next decade. Most retirees can't afford to live with that very low return potential. They need the higher return potential that comes along with stocks.

The big risk is if you don't have any buffer assets in your portfolio.

As an investor, you need to make peace with having the volatility that comes along with stocks. But if you don't have any cash or bonds in your portfolio, the risk is that you might encounter some big equity market drawdown.

We have certainly had several over the past couple of decades where stocks lose a lot, and your choices then will be to withdraw from that portfolio. And if you do withdraw from your portfolio as it's declining, that leaves less of the portfolio in place to recover when stocks eventually do. So, it's suboptimal to go all-in on stocks.

You should ideally have some components of your portfolio that will hold their ground, and maybe even gain a little bit of value in periods of stock market weakness.

Retirees need to figure out how much stock exposure is the right amount to ensure that they are not derailing their longer-term plans.

Retirees must use their spending horizon and near-term spending needs to drive how much they should hold in safer investments and then, in turn, into how much to hold in stocks.

If a retiree is actively drawing upon his or her portfolio, I like the idea of having 8 to 10 years' worth of anticipated portfolio withdrawals in cash, in bonds.

  • 2 years: In my model portfolios I typically have two years set aside in cash investments. Very low return potential there, but you are able to definitely preserve your purchasing power.
  • 5 – 8 years: Then comes the money that retirees might expect to spend in the next 5 to 8 years after that. Here they can reasonably hold a high-quality fixed-income portfolio. And then the amount that's leftover is an amount that they can safely have in stocks.

The reason I arrive at that 10 years' worth of spending in safer investments is that we have had these periods where stocks have had kind of a lost decade where they've gone down and stayed down for an extended period of time. The idea of having those more liquid assets set aside is that you could cover yourself and your spending needs through that period of market weakness.

Of course, this is for an American citizen. Investors across the world can adjust to the macro picture in their respective economies by using this as a guide.

Keep dividends in perspective.

Many retirees are big fans of dividend-paying stocks, and they use the dividends to cover their income needs. I love the idea of retirees incorporating dividends into their portfolios. But I would caution against complete dependence on an all-dividend stock portfolio.

There is a risk of having an all-equity portfolio, even if it is composed of high-quality dividend payers. And the big one, which was one that we really saw during the financial crisis of 2008, was that sometimes some of the biggest dividend payers are forced to slash their dividends in periods of market weakness, in periods of broad economic weakness.

The risk for a retiree who is subsisting strictly on dividends, who doesn't have any buffer assets in the portfolio, is that those companies that they're relying upon do make dividend cuts, and the retiree is forced to make do on less or forced to resort to some other strategy that's suboptimal.

Even dedicated dividend payers probably want to have at least something set aside in safer assets to tide them through a situation like that.

Finally, many retired investors are comfortable embracing a healthy equity stake in their portfolios. Just ensure that you objectively figure out what is the right amount for you.

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