What Is The Right Amount In Bonds For Retirees?

Your most serious risk in retirement is not a temporary loss of portfolio principal but instead the long-term erosion of your income’s purchasing power.  That’s why I explained last week that holding a significant amount of stocks in your retirement portfolio is the best approach, as it reduces this risk as much as possible.  

The portfolio I provided for illustration was a well-diversified, 100% stock allocation.  This approach resulted in several inquiries from prospective clients — am I saying everyone should have 100% of their retirement portfolio in stocks? No.  I’m saying your retirement portfolio should probably be much more heavily allocated to stocks than it is today.  

But that’s relatively ambiguous; what is a sensible and more specific framework we can use to decide on the right amount of bonds for your retirement portfolio?

The Role Of Bonds

We know that the historical and future-expected return on stocks is far above that on bonds, an efficient market’s way of rewarding you for enduring the increased volatility and temporary losses that accompany stock investing compared to bond investing.  Over time, stock losses melt away, and what is left is a significant long-term accumulation of wealth for current spending or future use.  

It is in those short-term setbacks, however, that bonds can provide a role if appropriately used.  The redeeming characteristic of bonds is that they tend to hold their value and even appreciate slightly during equity market declines.  Therefore, holding a few years of your future spending in bonds, to act as a “bridge” that can be accessed during bear markets for stocks (declines of -20% or more), can make sense.  This approach can help you weather the unpredictable but inevitable declines without selling shares of stocks at temporarily depressed prices.  It’s not absolutely necessary to allocate to bonds, even in retirement.  Still, as a behavioral tool to keep you from panicking and bailing out at the worst time, bonds are worthy of consideration.

Be Informed About Bear Markets

To decide on the right amount to hold back in bonds, if you so desire, we need to research how long bear markets last and, therefore, how long you might need to rely on bonds.  Fortunately, we have over 25 years of data for live asset class mutual funds in all corners of the global equity market, which can rightfully be considered the “Modern Era.”  Let’s take a look:

The table above lists the ten worst declines for the DFA Equity Balanced Strategy — a globally diversified, small cap and value tilted stock portfolio — since 1995.  We can see there have been five separate occasions where the stock portfolio has declined by -20% or more (“Drawdowns” tells you the maximum decline).  Last year it lost almost -30%, and in the ’07-’09 Great Financial Crisis, it declined almost -60%! We get a bear market about once every five years.  

Contrary to investor expectations, there isn’t a bear market lurking around every corner (or quarter).  When stocks drop significantly, the declines don’t last long (see the column titled “Length”).  The ’07-’09 plunge lasted just one year and four months, with the other four bear markets only lasting three months, five months, and four months.  The “corrections” were similarly brief; there were five other declines between -8% and -15%, all lasting just 2 to 11 months.  

How should we make investment policy out of these market realities?

Keep two years of future spending in a short-term bond fund, sufficient to weather bear markets without having to sell stocks when their prices are significantly depressed.  If you spend 4% to 5% of your retirement portfolio annually, this equates to an asset allocation of approximately 90% in stocks and 10% in bonds.

Covering The Recovery

What if you want to be highly conservative and don’t just want to have enough of your income set aside to cover the declines but also to tide you over during the recovery back to new all-time highs?  The table above also reports the “Recovery Time” and total “Underwater Period.”  The longest peak-to-trough-to-new-peak period was just three years and six months, a half-year shy of four years.  Other periods outside the ’07-’09 period were far shorter: less than two years each time.

Keeping four years of future spending in a short-term bond fund to get you through a bear market and a recovery, you would then need about 20% in bonds and 80% in stocks.

Every Bond Counts (Against You)

So we see something between 80% and 100% in stocks in retirement makes the most practical sense, giving you the lowest risk of your future income stagnating or declining on a purchasing-power basis.  The right allocation will depend on your comfort level with having a certain amount of your spending set aside from stocks, a conversation I have at length with new clients.

One thing I find, especially when investors are coming from portfolios that are much more heavily weighted in bonds — 50%, 60%, sometimes even 80% to 90% — is that they opt for the least amount of stocks (the most bonds) I suggest, the 80/20 mix.  Sure, 80/20 is better than their current mix by a mile, but you should not rule out the other options ultimately being better for you.

Consider what we find in the case of a hypothetical investor with $1M who retired in 1995 needing $40,000 per year, adjusted for inflation and net of the standard Servo advisory fees of 1% per year (0.5% on amounts between $2M to $10M, and 0.25% above $10M).  The three scenarios below simulate investing 100% in stocks (“Equity”), keeping aside two years of spending in bonds (90/10 allocation), or five years of spending in bonds (80/20 allocation).  

If you thought these were minor decisions, think again.  There’s a big difference in lifetime outcomes:

The retiree who opted for the all-stock allocation (“DFA Equity Balanced Strategy”) ended in May 2021 with $6.4M net of all withdrawals and fees.  Keeping just 10% aside in bonds lowered their ending portfolio value to $5.4M, which was $1M less and the total amount they had invested when starting in 1995!  With 20% in bonds, they ended with $4.5M, which is $2M less than the all-stock investor and double the amount they started with in retirement!  

It can take a while, but even small reductions in your bond allocation/increases in your stock allocation can have a life-altering impact on your overall wealth and increased ability to spend more as you get older. Consider that the all-stock investor could have started taking out $55,000 per year in 1995, increased annually by inflation, and ended at the same place ($4.5M left) as the 80/20 investor did at just $40K yearly withdrawals. That’s over 37% more income every year.  The difference in lifetime income to the higher returning all-stock portfolio?  Over $500,000.  A little bit more in stocks really adds up over your lifetime.

Pulling It All Together

Contrary to the conventional “age-in-bonds” formula, retirees don’t need more than a few years of their future spending in bonds to act as a spending bridge during unpredictable but temporary bear markets.  How many years?  You have to decide, either by yourself or with the help of a financial advisor such as myself. Whatever you choose, realize the decision is crucial: even minor differences in your stock & bond allocation can make a huge difference in your lifetime wealth and retirement income.

Choose wisely, and if you need help with the decision, don’t hesitate to contact Servo for a retirement plan review.