The stock market has been on a tear for much of the past decade, with annualized returns of about 12 percent through the end of July 2023. At the same time, interest rates have hovered near record lows over the past 10 years, which may have caused stock allocations to increase in retirees’ portfolios as investors chased higher returns in the stock market.

So how much should you have invested in stocks once you’re retired? Here’s how to think about asset allocation during retirement and the risks of having too much allocated to equities.

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Asset allocation

Investors have typically invested their retirement portfolios in assets based on the amount of time they have remaining before they plan to retire. An investor with decades left to work before retirement will typically have a higher allocation of stocks in their portfolio because stocks offer higher returns and they have plenty of time to recover from short-term volatility.

As one gets closer to retirement, the portfolio allocation shifts toward safer investments such as bonds or other fixed-income securities because you’re closer to the time when you’ll need the money for various living expenses. You sacrifice the returns offered by stocks for the safety offered by bonds. But the exact percentage of stocks or bonds to hold can be tough to nail down.

Traditionally, a simple formula of 100 minus your age was often used to roughly determine the amount your portfolio should have allocated to stocks. For example, if you were 70 years old, you’d have about 30 percent allocated to stocks.

“That formula is generally a good place to start,” says Keith Beverly, chief investment officer at wealth management firm Re-Envision Wealth. But Beverly says the exact number will depend on a variety of factors such as the risk profile of the individual, the economic cycle and the types of stocks a portfolio holds.

Investors aged 70 and older had about 42 percent of their portfolios allocated to stocks at the end of 2022, according to a Vanguard report on retirement plans it oversees.

Target-date funds

Many investors have essentially outsourced the asset allocation decision by electing to use target-date funds in their portfolios. These funds are managed with a set retirement date in mind, gradually shifting the portfolio’s assets toward safer investments such as bonds as the target date gets closer.

But target-date funds can have higher stock allocations than you might expect. The Vanguard Target Retirement 2025 Fund (VTTVX) has about 56 percent of its assets in stocks as of August 9, 2023, well above what’s suggested by the “100 minus age” formula. The Vanguard Target Retirement 2035 Fund (VTTHX) has about 72 percent of its assets in stocks.

Lazetta Rainey Braxton, co-CEO at financial planning and wealth management firm 2050 Wealth Partners, says today’s retirees may need to hold more stocks than previous generations in order to ensure their portfolios last for the long term.

“I understand that retirees may be a little hesitant about risk – the question is how much can they afford to take, knowing that they’re going to need the growth,” Braxton said.

A 70-year-old investor who holds 30 percent in stocks and 70 percent in fixed income may struggle to meet their spending needs if they live into their nineties, Braxton says. “Is the (fixed) income portfolio generating enough money to carry another two decades? The answer is typically ‘no’.”

Stock market risks during retirement

Both Braxton and Beverly agree that there are risks associated with having high stock allocations during retirement, but the right amount will vary from one individual to the next. A retiree who is able to live comfortably on Social Security and income from a pension may be willing to be more aggressive in their portfolio, with the goal of passing on their wealth to the next generation.

However, if you rely on your retirement portfolio for income, having a high stock allocation increases the possibility that the money won’t be there when you need it to meet living expenses. Stock prices are volatile and you could be forced to sell during a market downturn if you need the money.

Beverly suggests seeing how your portfolio would perform in a worst case scenario as a way of determining if you have your asset allocation approximately right. Look at whether you could meet your spending needs if stocks fell 30 percent or more, as they have plenty of times throughout history.

“Once you get comfortable with the worst case scenario, then you know that’s likely the right portfolio for you,” Beverly says. Otherwise, you may need to adjust your portfolio to a more conservative allocation by increasing bond exposure, he added.

Higher interest rates create an opportunity

Interest rates have risen significantly in the past couple of years as the Federal Reserve hiked rates as part of its efforts to slow the economy and tame inflation. The increase in rates has made bonds more attractive than they’ve been in some time, potentially creating an opportunity for retirees to de-risk their portfolios.

Investors have a chance to lock in higher yields of four or five percent, which is only slightly below long-term stock market returns, Braxton says. The bonds come with a lot less risk than stocks, making it a great time to diversify your portfolio between the two asset classes, she added.

Beverly also sees an opportunity for investors to get more defensive. Retirees should favor bonds in the current environment and more conservative investors in particular should have portfolios tilted toward fixed-income investments, he said. Stock allocations can also be more cautious by focusing on defensive industries like consumer staples and utilities.

Bottom line

The right stock allocation for retirees will vary based on an individual’s circumstances, but should generally be decreasing as you age. Consider working with a financial advisor to stress test your portfolio and understand how you’d fare under a worst case scenario. Now may also be a good time to increase fixed-income investments to take advantage of higher interest rates. These investments come with less risk than stocks and can help generate much-needed income during retirement.