Rethinking Equities and Retirement Income

The asset allocation rule of thumb in financial planning holds that an individual’s portfolio should be allocated to equities according to the formula “100 minus his or her age.” For a retiring 65 year old, this would mean a 35% equity allocation. The logic behind the rule is simple: as people get older, they should dial down their risks as they have less time to recover from any financial mistakes. But like any rule of thumb, it can be clumsy, and even misleading, no more so than today when advisors searching for ways to provide their clients with retirement income are confronted with unprecedentedly low interest rates.

“To generate income today, investors may need to move a little further up the risk spectrum,” states J.P. Morgan Funds’ Market Strategist Andrew Goldberg. Yields on CDs and the like, already extremely low in nominal terms, are actual negative in real terms when inflation is factored in. Equities are indeed riskier than CDs, but offer higher real returns, 6.5% on average  according to 2009 research from the Boston College Center for Retirement Research. Advisors looking for a retirement income strategy should note that historically, most of these returns have come from dividends. More detailed analysis of the potential spend-down income benefits of a portfolio tilted to high and growing dividend paying stocks was conducted by researcher Jack Gardner, looking at the time period 1968-2007. His article, “the case for a high and growing dividend stock strategy in retirement portfolios,” was published in IMCA’s (Investment Management Consultants Association) Investments & Wealth Monitor, (Nov, 2008). It found that a dividend focused strategy composed of the S&Ps top 100 dividend payers, compared to simply holding the broader S&P 500 index, increased a portfolio’s “sustainability and improved retirement lifestyle via greater withdrawal rates.”

Where does this leave advisors searching for the income component of the retirement equation? As J.P. Morgan Funds’ Andrew Goldberg rhetorically asks, “do you recommend stocks as part of the equation?” Much of the answer depends of course upon the advisor’s market outlook, and the client’s risk tolerance, needed expenditures, and other sources of retirement income. Additionally, one limitation of the study in the IMCA journal is that it only compared a high and growing dividend strategy to holding other equities, not to fixed income.

But with real returns from seemingly safe investments like cash, CDs, or savings accounts negligible, or negative, it is clear that equities in retirement portfolios are a risk worth revisiting as one potential source of retirement income, even if this contradicts the conventional wisdom. And given today’s interest rates, it might be time to finally retire the “100 minus your age,” equity asset allocation rule of thumb.


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