The Essential Guide to Asset Allocation for a Secure Retirement
A common question from our clients who are approaching retirement age is whether we should consider adjusting their asset allocation given this big life event. Suddenly, you will no longer be contributing to your accounts and will instead be taking money out of your retirement savings! The truth is that there is not one standard answer for any given person. The right asset allocation for you depends on several factors: your retirement timeline, your tolerance for risk, your spending goals and your sources of income outside of the portfolio. It is important to review each of these factors to determine if a shift in asset allocation as you transition into retirement is right for you. Here are some steps you can use to think through this question for your specific situation.
1- Assess your current asset allocation.
Asset allocation refers to the mix of stocks, bonds and cash in your investment portfolio. A higher percentage of stocks in your portfolio will mean you are taking on more risk or volatility and expecting a higher overall growth potential to help you keep up with inflation. This would be considered a more aggressive asset allocation. A higher percentage of bonds, on the other hand, indicates a lower risk level with lower expected returns. This would be considered a more conservative asset allocation. Financial advisors will often refer to an investment portfolio by these percentages. For example, a 60/40 portfolio typically means 60% of the investments are in stocks and 40% are in bonds.
One thing to note is that “stocks” or “bonds” often refer to a mutual fund or exchange traded fund (ETF) composed of many holdings rather than individual stocks or bonds. There are also many categories within the broad stock or bond asset classes such as international stock funds. real estate funds and short-term bond funds. A well-diversified portfolio will incorporate this variety into your investment strategy. Your mix of these different assets should reflect your risk tolerance, investment time horizon and the investment return that is needed for you to meet your retirement goals.
2- Evaluate your other income sources in retirement.
Most people will have at least one source of income in retirement- typically in the form of Social Security benefits. Some may also have access to pension benefits, rental income or perhaps even part-time work. It is important to get an estimate of your annual income from all these sources in retirement so that you can determine what you will need to take out of your investment portfolio as a supplement to support your financial goals.
3- Determine your spending needs in retirement.
It can be hard to think through spending in retirement, which makes sense as you’ve never been retired before! We find it can be helpful to look at dividing up your retirement spending into two main buckets. The first bucket is made up of your regular, more fixed budget such as mortgage payments, insurance premiums and groceries, etc. Our clients often find that the total of these expenses doesn’t dramatically change as you move into retirement which means you can use your current annual budget as a reasonable estimate.
The second bucket is made up of one-time or variable on-going spending. This would include things like a special anniversary trip, replacing a car, buying a second home and your desired level of retirement travel spending (often quite different than while you were working). These types of spending tend to be easier adjust if needed to allow for flexibility.
4- Determine the appropriate asset allocation mix for your initial retirement.
Now that you know your current mix of stock funds, bond funds and cash investments, it’s time to determine if it is the right asset allocation for you given your retirement timeline and income goals.
When we are assessing this with our clients, we look at their first bucket of spending- the regular, fixed expenses. This gives us the estimated annual cash that will be necessary as a baseline. We then incorporate any sources of retirement income to see how much funding will be needed from the retirement portfolio. For illustrative purposes, let’s say that the Smith’s will need $75,000/year to cover their first bucket spending and will have $40,000/year of Social Security benefits. This leaves $35,000/year of spending needs that must come from the investment portfolio.
We then look at the current investment allocation to determine if it is likely to be able to withstand a downturn in the stock market. To do this, we look at the total dollars in bonds and cash across the investment portfolio and see how many years of spending need are available in these relatively less volatile assets. To continue with the Smith’s, let’s assume they have $2 ML across all their investment accounts and that they currently hold 70% stocks and 30% bonds/cash. This means that they currently have $600,000 in bonds and cash and could fund 17 years of their $35,000/year spending needs from the portfolio without touching any of the stock mutual funds.
We encourage clients to have at least 7-10 years’ worth of the core living expenses they will need from the investment portfolio in bonds and cash. This should help to provide a safer place to generate the cash needed to live on when we live through another large stock market downturn and recovery cycle. In the case of the Smith’s, their 70% stock and 30% bonds/cash allocation should be more than sufficient and in fact they could consider being more aggressively allocated depending on their risk tolerances.
We also work with clients to have some of their bond allocation in cash or cash equivalent investments such as CD’s (certificates of deposit), money market funds and US Treasury notes. This helps to provide a buffer against the potential for years where both stock and bond performance are negative- a relatively rare event but still possible.
5- Adapt your strategy over time.
After you determine if your current asset allocation is appropriate or if you need to make some changes, the work is still not completely done. It’s important to monitor your mix of assets over periods of time and regularly rebalance the portfolio back to your target asset allocation. Rebalancing is the action of selling from asset classes that are overweighted and re-investing in the underweighted categories to get back to your target.
The first several years of retirement are also especially critical to your long-term success. Going through a large stock market drop early on in your retirement plan means that you will be taking a larger percentage withdrawal from your investment assets given their decrease in value. In turn, it will then take longer for them to fully recover. It may be necessary to consider other actions you can take to help lower your withdrawal rate and make your investments last longer such as timing of when you are claiming Social Security and cutting back on discretionary spending where possible.
Other Key Considerations: Withdrawal Strategies & Taxes
Looking beyond your specific mix of investments, it is also a good idea to determine if your planned rate of withdrawal from the investment portfolio is likely sustainable. One simple rule of thumb you can use is the 4% rule. There is much current debate and various opinions on whether this rule is too conservative or not, but for a quick check, take your planned withdrawal rate and divide it by your total account value. For the Smith’s, this would be $35,000 divided by $2 ML which comes out to 1.75%. This is well below 4% and therefore should likely be a very safe rate of withdrawal. Let’s assume the Smith’s also have some travel budget and one-time spending planned so that their desired annual distribution amount is $50,000. This increases their rate of withdrawal to 2.5% and should still be quite sustainable.
Another consideration beyond asset allocation is the important role of taxation of distributions. Any withdrawals you plan to take from tax-deferred accounts such as traditional 401ks or IRAs will be fully taxed as ordinary income in the year it leaves the account. This means that your pre-tax IRA value is not fully available to you- some will be lost to taxes. If you have a variety of account types to withdraw from – including a taxable brokerage account and/or Roth IRA- it is crucial to make a plan for how much you are withdrawing from in each account to minimize taxes and make your investments last longer. Check out our past blog post on how to pay yourself in retirement for more information.
As you can see, it’s important not to follow a cookie cutter plan when it comes to considering your asset allocation in retirement. Each person has a different situation and needs to consider all the factors before making a decision that may have a big impact on their retirement success. We recommend working closely with a financial advisor for investment advice and making sure you fully understand your personal situation and what changes to make (if any) to keep you on track for your financial goals. Be sure to schedule a Learn More Call with us if you’d like to find out more about how we work with those approaching retirement.
Liz Alf is the Principal of Clerestory Advisors and fee-only CERTIFIED FINANCIAL PLANNERTM located in Minneapolis, MN. She is a member of the National Association of Personal Financial Advisors (NAPFA) the Fee Only Network and Wealthtender. She enjoys serving clients with on-going financial planning and investment management services.