How to succeed in retirement: Stocks and 4 percent withdrawals

How to invest a nest egg and what is a safe withdrawal rate are the two biggest questions for anyone in or near retirement. Although the answers are far from simple, a lot of recent academic research continues to shed light and offer guidance to the perplexed.

The uncertainties of future inflation, investment market returns, and individual life expectancy can make it a bewildering calculation for many would-be retirees. Will inflation be a big factor, in which case should they take risks with stocks in order to keep up? Or will the stock markets suffer a spectacular fall, so that a more prudent approach would be keeping everything in the bank? And, most of all, how much can be taken out of an investment portfolio so that it will last for 25 years or more?

One finding that consistently appears in academic research on retirement income suggests that stocks should be in most retirees’ portfolios, despite their high volatility. In fact, most research suggests that the only two investments that can be relied on to match or beat inflation are stocks and Treasury inflation protected bonds, or TIPS. TIPS keep up with inflation but rarely pay a premium. Because medical inflation can run ahead of the official inflation rate on which TIPS adjustments are based, retirees may need some stocks to provide excess returns.

One recent study by John Okunev, an Australian portfolio manager, found that the optimal portfolio for a retiree should have as much as 80 percent of its holdings in stocks. This is even higher than earlier studies that suggested a retirement portfolio hold from 50 percent to 75 percent in stocks. Okunev based his research on 140 years of stock market returns, beginning in 1870. He found that portfolios with more stocks than bonds had a good chance of surviving an annual withdrawal rate of 4 percent over 30 years.

Another idea gaining acceptance is the use of a fixed annuity along with an investment portfolio. Annuities are insurance products that offer a guaranteed monthly income for life, no matter how long the owner lives. Buyers must permanently give up their principal to buy an annuity income stream, however, and that has been a big impediment to annuity sales in the past.  A fixed annuity—much like a pension—can be an excellent way to cover the bare essentials, while the investment portfolio is used to supplement the retiree’s cash flow, as needed.