(PUB) Investing 2016

17

September 2016

Morningstar FundInvestor

income-replacement rate. An accumulator who assumes a middle ground—that a Social Security benefit will be there but reduced by a pessimistic one third—would need to save 12% of her annual salary to achieve an 80% income-replacement rate.

a plan with 100% odds of being successful. The risk of spending their later years destitute—or having to rely on adult kids or other family members for finan- cial support—is simply too terrible to ponder. But retirement-planning experts say that unless inves- tors are willing to accept some probability of failure, their only option is to hunker down in very safe invest- ments, such as cash and Treasuries, and put up with an unpalatably low spending rate (or an exceptionally high savings rate for accumulators). Instead, most retirement-planning specialists believe probability-of- success rates of 75% to 90% are acceptable. Venturing into higher-risk investments takes the probability of success below 100% , but it also allows for the possibility of a higher return. If a retiree needs to course-correct by reining in spending, that’s not going to result in a catastrophic change in his or her standard of living. Stock market valuations, while not ridiculously lofty, aren’t cheap, either; that portends lackluster returns from the asset class over the next decade. Meanwhile, current yields have historically been a good predictor of bond returns; the Barclays U.S. Aggregate Bond Index is currently yielding less than 2% . For sure, those ominous signals suggest knocking down your return expectations for the next decade or so. On the other hand, investors with longer time horizons to retirement may experience muted results over the next decade or more, but for them it’s safer to assume that the returns they earn from their stock and bond portfolios beyond that time frame will be more in line with historical norms. Although U.S. stocks have historically returned roughly 10% and bonds about 5% , investors with very long time horizons may want to give those numbers a small haircut to account for muted near-term expectations; 7% to 8% seems reasonable for stocks, and 3% to 4% for bonds. Based on those assumptions, if I were estimating the very long-run return expectation for a portfolio with 60% in equities and 40% in bonds, I’d use 5% to 6% . K Contact Christine Benz at christine.benz@morningstar.com 4 | Assuming too little help from the market if you have a very long time horizon

2 | Taking a too-low withdrawal rate later in retirement

Many retirees and pre-retirees have gotten the memo about the risk of overspending in retirement, espe- cially if we encounter a period of muted future market returns. Retirees who encounter a bad market in the early years of their retirements and overspend at that time risk permanently impairing their portfolios’ sustainability, because too few assets will be in place to recover when the market does. I’ve talked to many retirees who withdraw a fixed percentage of their portfolios year in and year out to help tether their withdrawals to the performance of their portfo- lios; others tell me they use an ultralow percentage, like 2% or 3% , even well into their 70 s and 80 s. Conservatism is their watchword when it comes to portfolio withdrawals. That’s fine for retirees whose portfolios are large enough to afford a decent standard of living with a modest percentage withdrawal rate. And as noted earlier, some retirees may prioritize not spending all of their assets so that they can leave something to their children or heirs; they’d rather be frugal than jeopardize their bequest intentions. But for other retirees, especially those who are well past the danger zone of encountering a weak market early in retire- ment, a higher withdrawal rate is reasonable, especially if it affords them expenditures that improve their quality of life. While it’s decidedly unsafe for a 65 -year- old to take, say, an 8% withdrawal, it’s not at all kooky for an 85 -year-old to do so. “The 4% rule” for retirement spending, while not perfect, does a good job of scaling up spending as the years go by; the initial dollar-amount withdrawal gets adjusted upward year after year to keep pace with inflation. 3 | Gunning for a 100% probability of success If you were to ask investors what probability of failure in their retirement plan they might be comfy with, chances are they’d say 0% . In other words, they want