When planning for retirement, investors often consider the age they plan to retire rather than how long they expect to live in retirement. At first glance, there is seemingly little difference. However, as life expectancies increase, you may be retired longer than you originally expected—or planned for. This is why, in our view, a better approach to retirement planning begins by understanding your investment time horizon. Your investment time horizon is a major determinant of your total retirement costs—yet it is typically one of the most overlooked factors among today’s retirees.
In our view, the first step in your retirement planning process should be to define your investment goals—cash flow, growth or some combination. Then, you should estimate your time horizon.
Simply put, your investment time horizon is the length of time you need your portfolio to work for you. Depending on your investment goals, your time horizon may consist of your life expectancy and the life expectancy of your spouse—with some variability depending on your objectives. Knowing how long your portfolio needs to last should help to determine how to diversify your portfolio with an appropriate asset allocation mix of stocks, bonds, cash and other securities.
But there is a catch. We believe current average life expectancies underestimate how long people will likely live, given ongoing medical advancements. The table below shows total life expectancies for Americans, based on current age. But these projections are just averages—and planning for the average isn’t optimal because about half the people in each age bracket are expected to live even longer. If you are active, in good health and have parents still alive in their 80s, you could beat the averages. The last thing you want to do is plan for a 25-year time horizon and find out when you get to 85 that your retirement funds have almost run out. And let’s not forget your spouse. What if he or she lives to 95 or longer?
Exhibit 1: Average Life Expectancies
Source: “United States Life Tables, 2013,” National Vital Statistics Reports, Volume 66, Number 3, revised as of 4/11/2017. https://www.cdc.gov/nchs/data/nvsr/nvsr66/nvsr66_03.pdf. Life expectancy rounded to nearest year.
Age is an important factor in retirement planning and figures into your time horizon. But when looking at asset allocation, age and time horizon should be considered along with return expectations, cash flow needs, risk tolerance and liquidity needs, among other factors. If you fail to plan for a long enough time horizon, it could potentially mean you run out of funds in retirement. Let’s look at some of the implications of time horizons on asset allocation:
Data show that, over the longer term, stocks have had higher historical average returns than bonds. The longer-term growth potential of stocks comes at a price: higher short-term market volatility. However, over longer periods, stocks’ return variability tends to decline and fall below that of bonds. Exhibits 2 and 3 illustrate this effect in hypothetical portfolios that have different allocations to stocks and bonds measured over 5- and 30-year periods. Over a five-year time frame, portfolios with heavy stock allocations have higher growth potential but also higher return variability, measured by standard deviation.* But when you look at a 30-year time horizon, you see that portfolios weighted toward stocks have maintained higher average returns with lower return variability than portfolios that have more bond exposure.
Exhibit 2: 5-Year Time Horizon
Exhibit 3: 30-Year Time Horizon
*Standard deviation represents the degree of fluctuations in historical returns. The risk measure is applied to 5-year and 30-year annualized returns.
Source: Global Financial Data, as of 5/1/2017. 5- and 30-year rolling returns from 12/31/1925 – 12/31/2016. Equity return based on the S&P 500 Total Return Index. Fixed Income Return based on Global Financial Data’s USA 10-year Government Bond Index.
Cookie-cutter rules of thumb and life expectancy tables imply that investors of the same age are identical: Two people of the same age might not have identical portfolio asset allocations. Each investor may have different goals, income needs and life expectancies—which is why you should consider your potential investment time horizon when making portfolio asset allocation decisions.
Our Investment Counselors seek to understand your financial needs and will regularly check-in with you to make sure your investment goals remain consistent with your original objectives and investment time horizon. Call us at 1 (888) 823-9566 or contact us online to learn more.