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Getting out of the Market in Retirement?

A reader writes in, asking:

“An acquaintance emailed recently to ask input on her portfolio. She said her ultimate goal is to get out of the stock market. This woman and her husband are both retired and in their early 70s I think, with no extreme wealth. I assume they are comfortable enough but live simply and likely need to watch expenses.

When I asked what her concerns were about the market, she replied ‘political objections, volatility, ignorance..lack of control..risk aversion..Would consider investing in something I could believe in..’

Can you point me to any resources (articles, books, charts) that clearly explain why getting out of the market probably isn’t a good idea?

Any thoughts about how to respond to something like this?”

The idea of getting in and out of the stock market necessitates a belief that the market is predictable in the short-term. And it is not.

People are always looking for ways to predict short-term market movements — a reliable such method is basically the holy grail of investing. Of course, nobody ever finds it. For example, here is a well known study that looked at over 5,000 different trading rules and found that they “do not add value beyond what may be expected by chance.”

The best stock market predictor I am aware of is the concept of valuations (which can be measured in an assortment of related ways). It’s useful (though not at all perfect) for longer-term predictions, but essentially useless for short-term predictions. Here’s a recent article from Larry Swedroe on that topic.

But a separate question is whether a retiree might want to permanently get out of the stock market (i.e., not attempting to move back and forth between stocks and bonds at advantageous times, but rather simply electing to have a permanent 0% allocation to stocks).

And that isn’t necessarily such a bad idea, depending on circumstances. Many experts think it’s entirely reasonable (wise even) to prioritize building a sufficient pool of safe assets to fund retirement before allocating any part of a retirement-stage portfolio to stocks.

For example, the following two quotes come from Bill Bernstein’s book The Ages of the Investor.

“As one approaches the end of one’s human capital and hopefully has accumulated enough investment capital to safely offset the expense of retirement living, it makes little sense to put at risk the funds earmarked for retirement living expenses. In other words, once the game has been won by accumulating enough safe assets to retire on, it makes little sense to keep playing it, at least with the ‘number’: the pile of safe assets sufficient to directly provide or indirectly purchase an adequate lifetime income stream.”

“If, at any point, a bull market pushes your portfolio over the LMP [liability matching portfolio] ‘magic number’ of 20 to 25 times your annual cash-flow needs beyond Social Security and pensions, you’ve won the investing game. Why keep playing? Start bailing. After you’ve put enough TIPS, plain vanilla Treasuries, and CDs into your mental LMP, you’re free to start adding again to your RP [risk portfolio].”

Or as many people have quoted him since: “if you’ve won the game, why keep playing?”

When comparing various stock/bond allocations, this 2015 paper/article from Wade Pfau may be of interest. In that paper, we can see that once we look at horizons greater than 20 years, it becomes clear that having some stocks is helpful relative to an all-bond portfolio, in the sense that those stocks will reduce the likelihood of running out of money.

But there are important caveats:

  • Probability of portfolio depletion is not the only relevant metric here. In the failure scenarios, we don’t just care that a failure occurred (i.e., portfolio was depleted), we want to know when it occurred. That is, in the scenarios in which the portfolio is depleted prior to death, it makes a big difference to the retiree whether the depletion occurred 15 years into retirement or 25 years into retirement. And a risky allocation can result in depleting the portfolio sooner than would be the case with a super safe allocation.
  • If the goal is just to maximize spending over their lifetimes in as safe a way as possible, a boring (likely inflation-adjusted) joint lifetime annuity is probably the best tool for the job rather than stocks.

With regard to that first caveat, this paper from Joe Tomlinson may be of interest.

Key questions that could help determine how much of their portfolio should be annuitized (and how to allocate the non-annuitized portfolio) would be:

  1. What type of health are they in (i.e., what type of planning horizon is necessary)?
  2. How much (what percentage of the portfolio) is the couple hoping to spend per year?
  3. How flexible is the answer to #2?
  4. How strong is their “bequest motive” (i.e., desire to leave behind money to heirs)?

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Investing Blog Roundup: Preparing for the Possibility of Cognitive Decline

One concern I know many readers here share is the possibility of diminished cognitive ability as they age. Many of you who are already retired have mentioned to me that you have opted to simplify your portfolios (in some cases switching to an all-in-one fund). And some of you have mentioned such concerns as one of the reasons you chose to delay Social Security and/or purchase an annuity.

This week we have an article from CPA/CFP Jeffrey Levine, walking you through the basic options for different types of accounts/documents that can allow your family members to help manage your finances, in the event that you do end up needing such help.

Other Recommended Reading

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The Effect of Taxes on the Social Security Filing Decision

A reader writes in, asking:

“Could you write something explaining the effects of taxes on the age you decide to begin Social Security. Especially since RMD’s may be delayed to age 72 under new legislation. Also, my state doesn’t tax Soc. Sec. benefits. Thanks.”

In most cases I have looked at, tax planning has worked out to be a point in favor of delaying.

The mechanism at work is that Social Security is, at most, 85% taxable. In contrast, distributions from tax-deferred accounts are usually fully taxable. And spending down your tax-deferred accounts in order to delay Social Security has the effect of increasing the portion of your lifetime income that is made up of (not-fully-taxable) Social Security and decreasing the portion of your lifetime income that is made up of (usually-fully-taxable) distributions.

And a similar thing is usually going on at the state income tax level. Only 13 states tax Social Security benefits, whereas a majority of states treat distributions from tax-deferred accounts as taxable income.

But, to be clear, the effect of taxes on the Social Security decision is very case-by-case. While the above effect is pretty broadly applicable, there could be any number of other factors that could point in the other direction. Almost anything that appears on a person’s 1040 could end up being a relevant factor in the analysis.

Ideally, the way to do the analysis (e.g., when comparing two possible claiming strategies) is to:

  1. Use tax prep software (or other similarly fully featured tax planning software) to estimate the total household tax bill year-by-year under each claiming strategy that you want to test. (For a married couple, you actually want to estimate 3 different tax costs for each year for each claiming strategy: a scenario in which both people are alive, one in which only Spouse A is alive, and one in which only Spouse B is alive.)
  2. Do a typical net present value calculation for each strategy, including the differences in tax costs as cash flows. For example, if you are comparing two strategies, and Strategy 2 has higher taxes by $1,000 in a given year, include that as a $1,000 negative cash flow for Strategy 2 that year. (Again, for a married couple, you would be doing three calculations for each year for each strategy — both spouses alive, only A alive, only B alive — then weighting each one by its probability, using a mortality table of your choosing.)

With regard to step #1, I would caution against using a spreadsheet or other similar DIY tax calculation. It’s very easy to accidentally fail to include a given credit/deduction/exclusion that would affect the analysis — especially when we consider state income taxes as well.

And of course it’s important to remember that all of this is just a projection. There are many unknowable factors involved.

Tangential note: my spreadsheet for doing step #2 of this analysis is what originally served as the starting point for the Open Social Security calculator. And it’s part of why I was surprised to realize that most (all?) other Social Security claiming calculators use a fixed life expectancy assumption in the calculation (i.e., assuming with 100% certainty that a person dies on a given date). Doing so is fine for an unmarried person, but for a married couple it significantly underestimates the length of time for which only one spouse will be alive. That really messes with the value of survivor and spousal benefits, and it also really messes up the expected tax cost calculation (because taxes change significantly once one spouse dies).

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  • How Social Security benefits are taxed and how that affects tax planning,
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Investing Blog Roundup: Taxes Made Simple, 2019

The 2019 editions of Taxes Made Simple and my book about taxes for sole proprietors are both now available. In contrast to the major changes that were necessary from 2017 to 2018 (due to the new tax law), the changes from 2018 to 2019 were relatively modest — inflation adjustments to various figures, minor improvements to wording here and there, etc.

Recommended Reading

Thanks for reading!

Simplifying a Retirement Bucket Portfolio

A reader writes in, asking:

If you were developing different “buckets” for a portfolio in retirement, what funds would you use for each bucket?

For our immediate 1-3 years, I have assigned that duty to the Vanguard Ultra Short Bond Fund. It has a duration of one year, and does not have any government bonds.

Do you think that fund is too risky – both in terms of duration and in terms of risk? Should we have at least one year in money markets?

For our 3-6 year buckets, we use a variety of short term bond funds – such as the Short Term Bond Index Fund, Short Term Investment Grade Fund, and the Short Term Corporate Bond Fund.

For 6-10 years, we use a variety of funds such as the Target Retirement Fund, and Wellesley (because the stock allocation is of extra large Value stocks). Also for this category we would consider the Life Strategy Conservative Growth Fund. Of course with this group our main investment is in the Total Bond Market Fund, with the others hopefully boosting returns over time.

For more than ten years, stock funds such as the Total Stock Market Funds, Total International Stock Market Fund, and the S&P 500, with a few exotic funds to spice things up such as the REIT. This portion is relatively small, as we will allocate our retirement duties to primarily bond funds, with a few funds such as what I mentioned before in the 6-10 year period. I look at the stocks as a really long term investment in the event more money is needed, but I will do some rebalancing of that bucket to take profits and put money in when the market falls.

What would be your suggestions? How many buckets and which funds go into each bucket?

Principle number one when it comes to crafting a portfolio is that it’s the whole portfolio that matters. This is why, for instance, it rarely makes sense to look at one account in isolation. And it is why the overall portfolio allocation is the important question here — both what allocation you want now, and how/if you want that allocation to change over time (i.e., your intended glide path).

Bucket strategies are psychological tools, not financial ones. That is, a bucket strategy can be helpful if:

  1. It helps you to arrive at an overall allocation (and glide path) that you’re happy with, or
  2. It helps you to stick with your overall allocation (and glide path).

For example, some people may find that the easiest way to settle on an allocation is to think of it in terms of buckets (e.g., “I want 3 years in short-term bonds, 7 years in intermediate term bonds, 15 years in stocks”).

And some people may find that having a bucketing strategy helps them to feel more comfortable sticking with the plan during a bear market (e.g., “I don’t have to worry about my stocks going down, because I have X years worth of spending in short-term bonds and Y years in intermediate term bonds”).

And some people may find that a bucket strategy may be the most intuitive way for them to implement a desired glide path. For instance, if you like the idea of a “rising equity” glide path (i.e., one in which your stock allocation rises over time, as suggested by Wade Pfau and Michael Kitces here), you might find that the most intuitive way to implement that glide path is via a bucket strategy in which you do not “refill” the shorter-term (bond-heavy) buckets (by selling stocks and buying bonds) as they get depleted over time.

But if you find that managing/crafting a bucket-based portfolio is harder than just focusing on the overall allocation, then it’s best to forget about the buckets.

What you’re describing sounds to me like it may be more funds and complexity than is necessary. Maybe that’s because of the buckets; maybe not.

For instance, you asked whether the Vanguard Ultra Short Bond Fund is too risky, and whether the portfolio should have at least one year in money markets. My questions there would be: how much of the portfolio is in the Ultra-Short Bond Fund? And how much would the portfolio’s overall volatility be affected by moving part of that money into a money market fund? (My guess would be “a relatively small portion” and “hardly at all.”)

And with regard to what you consider the 3-6 year bucket, what is the specific advantage (to the overall portfolio) of having three different short-term bond funds rather than just one?

Or more broadly I might ask, can you achieve the overall risk profile that you want using just a few funds (e.g., Total Stock, Total International Stock, Total Bond)? If not, why not? What specifically do you feel would be missing? (Alternatively, what do you feel that you’d have too much of?) And how could you fill that gap in as simple a way as possible?

For instance, if you like the idea of a larger helping of short-term bonds than you’d have with the Total Bond Market Fund, what about those three funds, plus a short-term bond fund? Would anything feel distinctly missing (or overweighted) then? (And if so, again, how could you correct whatever feels “off” in as simple a way as possible?)

Let’s assume for a moment that you would find those four funds to be sufficient. In that case, the portfolio could be thought of as a short-term bucket with a short-term bond fund, an intermediate-term bucket with a total bond fund, and a long-term bucket with total stock and total international stock funds. Or we could achieve the same thing by looking at it from the overall portfolio allocation perspective (e.g., 15% short-term bond, 25% total bond, 40% total stock, 20% total international stock).

If you find buckets to be helpful, great. But be sure, after creating a bucket-based plan, to step back and look at the whole thing at once.

  • How does the overall allocation look? Does it seem reasonable?
  • How will it change over time (i.e., will the equity allocation be roughly steady, increasing, or decreasing)? Do you like that?
  • Is there a way to achieve the same overall goal with fewer funds?

Investing Blog Roundup: “More Art than Science”

I’ve published ten books (not counting follow-up editions of various titles). Nine are still in publication.

Of those nine books, one of them generates 45% of the total revenue — almost as much as the other eight books combined. Prior to publishing the book in question, I would never have guessed that it would be so much more successful than the other books. And I’d bet that if you were to guess which book it is, you’d have a roughly 8/9 chance of getting it wrong.

One might say that publishing books is “more art than science.”

This week, Michael Batnick takes a look at the “more art than science” concept.

Other Recommended Reading

Thanks for reading!

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My new Social Security calculator: Open Social Security