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Why Bonds Aren't Enough for Your Retirement Income

I met Ian and his wife Patricia about six months ago. Patricia retired years ago, and now at age 72, Ian was calling it quits at work too. Ian had over $5 million in his retirement account and asked me how to best invest that money to maximize his income, adjusted for inflation, over his and Patricia’s joint lives. He needed to pull out a bit less than $200,000 (before tax) a year in order to have the kind of retirement lifestyle he wanted.

He told me he wanted to take as little risk as possible, which was completely understandable. He added that his strong preference was to put all the money in bonds, collect interest, and relax at the beach.

Equity Funds in Retirement Portfolios

I told him he could do all those things as long as he was willing to go back to work or move in with his kids at age 90. Based on my projections, that’s when he’d probably run out of money using his plan. Ian and Patricia didn’t like the sound of that so we explored alternatives. I explained that a better choice might be to include at least some equity in their portfolio to provide potential growth and income and to offset inflation.

Like Ian and Patricia, many people only think about bonds, and maybe dividend income when they think about investing for income. I understand that, but what many people fail to realize is that if you do it right, you can easily tap into growth mutual funds or ETFs to create monthly income to supplement your retirement. There are pros and cons to doing this. The best way to examine the benefits and costs is to walk through an example so you can see it for yourself. (For more from this author, see: Calculating How Much You Should Spend to Buy a Home.)

How to Not Run out of Money in Retirement

Assume you have a little less that Ian and Patricia and accumulate $500,000 in your 401(k) by the time you retire. You know you want a monthly income check but you don’t want to buy an annuity and you don’t want to put all the money in bonds because rates are low and you fear they might be going up soon.

Since you are only 65 years old now and may live beyond 90, you realize you may have a very long investment timeframe. You don’t like short-term volatility but the most important thing to you is not to run out of money. 

You weigh this all and decide to invest in a balanced portfolio of equity and fixed-income funds and set up a monthly withdrawal based on a 4% annual rate. On $500,000, that’s a total annual withdrawal of $20,000. The 4% withdrawal rate is adjusted up each year for inflation; in other words, your income goes up each year no matter what the market does. (For related reading, see: Why Has the Stock Market Gone Up Since the Election?)

This sounds good in theory of course, but your main question remains: will it work? Will your income last at least as long as you will? The answer is, probably. I say that based on the Trinity Study. This was an exhaustive report that examined the best way to invest to generate income, adjusted for inflation, over long periods of time. They looked at various portfolio allocations and a number of different withdrawal rates.

The study found that the maximum safe withdrawal rate was between 3% and 4%. And over a multitude of 10, 20 and 30-year time periods, equity investors had the highest probability of success. In other words, they had the lowest chance of running out of money. The Trinity Study also found that investors using a balanced approach who also withdrew 4% had a slightly lower success rate but it wasn’t significantly lower. Those who put all their money in bonds however, had a very high chance of running out of money before the given time period expired. (For related reading, see: How Much Retirement Savings Is Enough if You're 90?)

What to Know About Withdrawal Rates

The most important takeaway from the Trinity work is that this was a historical study and obviously, no guarantee of future results. 

The second most important takeaway is that nothing is perfect. Using this strategy, there will be several years where you withdraw 4% and your investments earn less than that or even lose money. And when a retired person sees their account value drop, the very account they depend on to create retirement income, they often get extremely anxious. This is understandable yet unavoidable.

The third big takeaway is that if your main goal is to maximize income over the long-run and reduce the odds of going broke, you must consider using equities in at least part of your portfolio. 

Again, this approach is not perfect. In fact, it can be downright painful at times. It’s just that this is the better approach when compared to an all-bond portfolio. It’s critical to make a decision based on the real alternatives and not just dismiss equity because it lacks certainty. When you factor in inflation, bonds expose retirees to even greater uncertainty if you are looking for retirement income over the long-term.

This is a good time to ask, how are you investing for retirement? How did you decide on this approach? (For related reading, see: How to Calculate the Costs of Buying a New Home.)