Three Key Investing Principles for Retirees

For investing purposes, retirement is when a portfolio is steadily and systematically drawn down over many years. Retirement presents particular challenges and risks for the investor, most critically:

• Running out of money due to living to a very old age (known as longevity risk); this forces a delicate balancing act between life expectancy, uncertain investment returns and lifestyle or spending rate
• Inflation, the year over year increase in the cost of living, which reduces the value of a dollar and can impoverish over a retirement period that can easily span more than a quarter century due to earlier retirement and increasing lifespans
• Negative market returns during the initial years of retirement (known as sequence of returns risk) which can reduce a portfolio so much at the start that it never recovers, even with subsequent good markets, and eventually causes the portfolio to be depleted 10 or 20 years sooner

Different types of investments may be beneficial or harmful to the retiree in meeting these challenges. For instance, equities provide higher long term returns than bonds, and are thus better protection against running out of money, but as was evident in the 2008 crash, they can be highly volatile, which increases sequence of returns risk. Bonds, cash, GICs and other fixed income on the other hand, are much less volatile but their value is susceptible to inflation and they may not provide adequate returns to ensure long term health of the portfolio in real terms. What lessons arise from such realities?

1. Equities should form part of retirement portfolios - in his recently published book, Are You a Stock or a Bond?, pensions and retirement planning expert professor Moshe Milevsky estimates that about 60-70% of a retiree's investment portfolio should be in equities. This holds true for a wide range of spending rates (he uses 5 - 9% of the portfolio spent per year) and ages of retirees (he uses 55, 65 and 75).
2. Diversification is particularly beneficial to retirees - Milevsky's book uses the example of an ultra-simple portfolio comprising only US large cap equities (the S&P 500) and cash (US money market fund) but there is a considerable benefit from this diversification. The portfolio does not include other important asset classes such as government and corporate bonds, real return bonds, real estate, international equities, value equities, small cap equities and commodities, the inclusion of which would drastically reduce portfolio volatility beyond what Milevsky calculates, as CanadianFinancialDIY notes in Benefits of Investment Diversification for Retirees. This can allow the retiree appreciably higher portfolio withdrawal rates or much lower risks of portfolio exhaustion or a combination of the two. One should also not forget the peace of mind that comes from a portfolio with much reduced swings in value.
   
3. Taxes can significantly alter actual net amounts available to spend - in Canada net tax rates vary tremendously from lowest taxed dividends to middle rated capital gains to highest level interest (see image below of rates for a net income level of $40,000 from the Ernst & Young 2009 Personal Income Tax Calculator). This factor reinforces the benefit of including equities in a retirement portfolio for the capital gains and the dividends such investments generate. There may be some opportunity to shape a portfolio according to income type e.g. to include a higher proportion of dividend paying stocks or funds, or to hold some preferred shares instead of bonds since they both tend to swing up and down according to interest rate changes to produce dividends instead of interest. A higher net after tax return can allow a lower withdrawal rate to produce the same amount to spend. The tax factor applies only to taxable accounts, not registered accounts such as RRSPs, RRIFs, LRIFs etc. since all withdrawals from registered accounts, however the return was generated inside the account, are taxable at the highest marginal tax rate.