Last Updated: November 3, 2008
Retirees with a portfolio of stocks and bonds face a tough decision: in what order should they withdraw their assets to pay for retirement in order to best extend the life of their portfolio? Should they sell off their stocks first, their bonds, or a combination of stocks and bonds?
Ninety percent of the time, withdrawing bonds first extends the life of a retirement portfolio longer than the other two strategies — but for today's retirees, a bonds-first strategy is "not worth the risk," according to a study in the November 2008 Journal of Financial Planning, published monthly by the
Financial Planning Association® (FPA®).
Two professors, Robert A. Weigand, a finance professor at Washburn University in Topeka, Kansas, and Robert Irons, an assistant finance professor at Dominican University in River Forest, Ill., compared the strategies of withdrawing bonds first, stocks first, or a 50/50 combination of stocks and bonds. They were then able to develop a reliable market signal that suggests which withdrawal sequence a worker should take when he or she retires.
Based on 136 years of historical data, the professors concluded that first consuming all of the bond portion of one's retirement portfolio results in the portfolio lasting longer than the other two strategies roughly 90 percent of the time. The strategy on average extends the life of the portfolio 2.3 to 3.8 years.
This result occurs because equities have historically outperformed bonds over the long haul. Much retirement research has advocated retirees maintaining a healthy portion of their portfolio in equities. Consuming bonds first allows equities more time to provide superior returns.
The challenge for retirees for the bonds-first strategy, however, is that it creates a much more volatile portfolio than the other two strategies because over time the portfolio becomes increasingly heavy in more volatile equities. In fact, the volatility of a bonds-first approach is twice that of the other two approaches.
If retirees are uncomfortable for the volatile bonds-first approach, which eventually leaves them with an all-equity portfolio, the least volatile strategy is equally withdrawing stocks and bonds from a 50/50 stock/bond portfolio. But if they want their portfolio to last as long as the bonds-first strategy, they'll need to reduce the percentage of the portfolio's value they withdraw each year.
For those comfortable with using a bonds-first approach, the authors found that the key to its longevity rests not merely on the fact that stocks outperform bonds on average, but by how large the spread of stock returns is over bond returns. The greater the spread, the more successful the bonds-first strategy.
This was so reliable that the authors investigated market signals that might forecast when the bonds-first approach would be most successful. They found that the higher the spread of the long-term earnings yield for stocks (the reciprocal of the market price/earnings ratio) for the 10-year trailing
earnings over bond yields for the same period, the better the bonds-first approach. When the spread was narrow, the performance of the bonds-first strategy was so weak that it wasn't worth it for the retiree to take on the extra volatility versus maintaining a 50/50 portfolio.