Choosing how to invest retirement savings often ends up being a dartboard exercise for younger people, because it all seems so theoretical.
As the date of retirement or semi-retirement gets nearer, however, you begin to realize that your financial choices have serious consequences. How you divvy up assets among stocks, bonds and other investments can be a key determinant of your future quality of life.
And once in retirement, it becomes crucial that your mix of assets matches your individual tolerance for risk — because you probably won't have a second shot at it.
Here's a primer on how your money should be invested in retirement:
•Think about cash first. Before the 2008 financial crisis, financial advisors usually suggested that retirees keep six to 12 months of living expenses in cash accounts such as bank money market accounts. Now, the typical recommendation is much higher — reflecting the trauma that investors suffered.
Bob Klosterman, founder of White Oaks Wealth Advisors in Minneapolis, thinks holding 18 to 24 months of expenses in cash is a good target. "That's almost always going to give you enough time to deal with whatever is happening," he said. The goal is to avoid having to sell investments in a down market to raise cash.
The problem with cash, of course, is that it pays very little. The average one-year bank CD yield nationwide now is 0.28%, according to Bankrate.com. It has inched up just 0.01 point since November despite the Federal Reserve's 0.25-point hike in its benchmark rate in mid-December.
•Build a base with bonds. Fixed-income securities remain the logical bedrock of a retiree's portfolio, even though they mostly pay low-single-digit yields and carry their own specific risks.
As the financial crisis demonstrated, investors still flee to high-quality bonds in times of economic or market turmoil and away from stocks and other higher-risk investments.
"In 2008 high-grade bonds were the only thing that went up in value," said Christine Benz, director of personal finance at Morningstar Inc. in Chicago. "No other asset class will be the ballast to stocks in a portfolio." That scenario played out again in the last few months.
But how big a bedrock of bonds is enough? One historical rule of thumb was that bonds should be the same portfolio percentage as your age. So at 60, a simplified recommended portfolio would be 60% bonds, 40% stocks.
With bond yields so low worldwide, however, owning a high proportion of bonds all but guarantees your future portfolio returns will be slim.
Sandi Bragar, a principal at wealth management firm Aspiriant in San Francisco, said her firm expects the bond portion of clients' portfolios to generate total returns averaging about 3% a year over the next 10 years, while they believe that U.S. stocks could return 6% to 7% a year.
But stocks carry much more risk than bonds, particularly over short periods of time. Of course, bonds have their own risks. If inflation ever rises again, and market yields on bonds jump, older fixed-rate bonds will fall in value (though they'll still be paying interest).
You can help mitigate those risks by spreading your bond investment over short-, intermediate- and long-term securities. And if higher interest rates are coming, that won't happen overnight. You will have some time to adjust your portfolio, if necessary.
•Consider counting likely future income in your bond portion. Bonds are supposed to provide relative safety. But you also have that in future income you can count on — especially Social Security and any corporate pension plan payments.
Likewise, if you've purchased annuities, that income is bond-like. And some investors choose to count the equity in their home toward the bond portion of their portfolio.
Fred Wallace, a 61-year-old retiree in Playa del Rey, figures that his future pension and Social Security income allow him to hold less in bonds now and more in investments that are riskier but also could produce higher returns over time.
•You need assets that can provide growth. If not stocks — what?
After two devastating bear markets in one decade — 2000-02 and 2008-09 — it's understandable that many retirees and near-retirees are terrified of stocks. The powerful bull market of the last seven years has pushed share prices to record levels. After a rough start to 2016, the Standard & Poor's 500 index is back within 3% of its all-time high reached last summer.
Yet the main underpinning for stocks — corporate earnings — has weakened significantly over the last year. In the first quarter, operating earnings of the S&P 500 are expected to fall 6.9% from a year earlier, according to analyst estimates from Thomson Reuters.
Financial advisors' biggest concern in building clients' portfolios is that stocks could face a long period of poor returns, after the huge gains since 2009. The global economy has slowed markedly again. If U.S. real annual economic growth stays in the 2% range "that is not a recipe for double-digit equity returns," Klosterman said.
Still, many advisors find it hard to justify keeping less than 40% of new retirees' portfolio in stocks. Even if the equity market gains just 5% a year over the next 10 years — half its historical average — that could easily be more than bonds or cash will produce.
And given that a 65-year-old could live another 30 years, that's a long time to allow stock returns to build.
Wade Pfau, professor of retirement income at the American College of Financial Services in Bryn Mawr, Pa., said the lifestyle that retirees expect to fund from their nest egg should dictate the share of stocks in the portfolio.
If you plan to start spending 4% of your assets each year, "a high stock allocation is going to be an important part of that," Pfau said. Being overloaded with bonds "just won't cut it."
Just as a bond portfolio's risk can be lessened via diversification, so too investors can reduce stock risk by having a well-diversified mix. And the simplest way to get that would be funds designed to replicate the broadest indexes of U.S. and foreign stocks.
For investors who have the wherewithal to diversify further, some advisors add so-called alternative investments, such as commodity-related funds and shares of commercial real estate mortgages.
But for most people, stocks and bonds will always comprise the bulk of a portfolio. Getting that mix right still matters most.
The trade-off is deciding on the assets you'll need to achieve your long-term goals, versus the amount of volatility you can handle along the way.
Bragar puts it another way: "We look at how much risk the client must take and how much risk they can stand to take."