A time-honored strategy puts your retirement at risk of financial ruin

And it did. The mutual-fund giant’s take on the classic, “safe" mix of 60% stocks and 40% bonds, which peaked in 2021, clawed back its losses by this February. But the fact that Vanguard felt the need to talk some customers off the ledge shows how poorly understood the approach is. Even worse, investors might be worried about the wrong retirement rule of thumb.

Most commonly understood as a 60% allocation to the S&P 500 stock index and 40% to intermediate bonds like 10-year Treasury notes, the ratio and exact holdings aren’t set in stone. It is just shorthand for a mix that gets you the best return for the least choppiness, according to modern portfolio theory. But 2022’s swoon was a reminder that money can still be lost: It was a 60/40 portfolio’s worst year after inflation since 1974, a year before Vanguard was founded.

With the Federal Reserve regularly riding to the rescue over the past quarter century, investors had been conditioned to expect bonds to act like a shock absorber, buffering a bad year for stocks. That is actually pretty rare, though, according to a 200-year retrospective by Morgan Stanley Investment Management.

Ironically, the lower bond yields are when a stock swoon begins, the less potential bond prices have to rise in a sharp economic downturn. If a recession caused yields on 10-year Treasury notes to drop to 1.5% today then their price would rise by about a fifth. Back in 1974, a plunge to the same yield would have spurred a rise of around 50%.

To academics, those temporary paper gains, and just being diversified generally, make your portfolio safer. Do they really, though? Maybe, if it makes it less likely that a saver will panic when they open their 401(k) statement, torpedoing their nest egg.

But owning lots of bonds also means settling for lower returns–another form of risk. After all, $100 invested in the stock market in 1928 turned into $787,018 by the beginning of this year, more than 100 times as much as owning Treasury notes and 350 times as much as short-term Treasury bills. No less an investor than Warren Buffett has told the trustees of his will to invest 90% of his wife’s inheritance in a stock index fund and just 10% in short-term Treasury bills.

With all due respect to Buffett, there is another reason the less-aggressive 60/40 mix has become a touchstone for retirees: sequence of return risk. An especially bad run for markets around the time someone starts to draw down their savings can have an outsize effect on how much they have to live off. And the ultimate risk for a retiree is running out of money.

The seminal work on how to avoid that was published 30 years ago by adviser William Bengen, who popularized the 4% Rule. It says a retiree can withdraw that percentage of their portfolio in year one and then increase it by the inflation rate for the next 29 years with very little chance of penury.

That 4% rate is tied at the hip with a 60/40 mix, or thereabouts. Most retirement products these days improve on the traditional blend by including things like real estate and international stocks. Rules of thumb aren’t foolproof, though. Bengen’s 4% Rule is based on a mostly prosperous and peaceful period for America. Even so, a person retiring in 1966, ahead of a bear market and a spike in inflation, cut it very close.

A recent academic paper that looks at 38 developed countries’ experience over many decades says that a retiree who wants no more than one-in-20 odds of “financial ruin" should withdraw just 2.26% a year. Put another way, someone with a $1.5 million nest egg should take out $34,000 in their first year of retirement, not $60,000–a huge difference.

America isn’t Japan, Sweden, or Australia, but don’t assume that it will be as exceptional in the coming decades as past ones. Uncle Sam’s interest-rate bill alone will exceed a trillion dollars next fiscal year–more than all discretionary, nondefense spending. Ruling out higher taxes, higher inflation or less willingness by foreigners to finance Americans’ lifestyles is foolhardy.

There are those vague worries, and then there are more quantifiable ones. Like the mutual fund boilerplate warns, “past performance is not indicative of future results." The 4% Rule almost always worked over a period when a 60/40 portfolio earned an average of about 9% a year or a 5.8% real return (after inflation).

Reliable predictors of returns point to numbers nowhere as high over the coming decade. Robert Shiller’s cyclically adjusted price-to-earnings ratio is now more expensive than it has been 97% of the time since 1880. Money manager AQR calculates that real stock returns over the 10 years following a 90th decile reading have averaged just 0.5%. Meanwhile, 10-year Treasury yields are only 3.86% after their recent retreat. Minus expected inflation over the next decade, that only comes to 1.65%.

And even if a retiree is completely confident in the 4% Rule, it was devised at a time when Social Security was seen as rock-solid. The latest report from the trustees of the Social Security fund calculates that monthly benefits will have to be reduced by 21% in nine years when the trust fund is depleted. If personal savings are needed to plug that lost income then someone retiring soon should consider preserving capital or saving more.

60/40 isn’t dead, but it isn’t a magic money tree either.

Write to Spencer Jakab at Spencer.Jakab@wsj.com