Asset Allocation in Retirement

One of the tricky parts about investing is understanding the best approach to take as you age and change from an early career worker to a veteran on the verge of retirement. Over the past few decades, less people have state sponsored pensions or guaranteed benefits, and need to rely on their regular investment portfolio to help meet their income needs. But there are two things that everyone needs to consider about their investments as they get older: 1.) how do I change my portfolio to produce reliable income, and (2) how do I adjust my portfolio to decrease risk over time? I’m going to focus on the latter question today, as there are many conflicting rules of thumb, and factors to consider as you age.

Younger people can afford to take more risk with their investments because they have the benefit of time. Time to wait out stock market declines, time to wait out economic or political uncertainty, and time to allow assets to compound and grow without using the income. But as people get closer to retirement, those assets will need to be used to produce interest and dividend payments to pay for living expenses. When you’re dependent on your assets for living expenses, severe market drops also impact your ability to produce income, and safely use your funds without depleting your savings. Many have heard of the “4% rule” that suggests most portfolios can continue to grow at a 4% withdrawal rate over time. But that doesn’t explain what ratio of risky (stock) to more stable (fixed income) you should have over time. In addition, the 4% rule assumes you have a healthy stock allocation to outpace inflation, and more conservative investors might find that withdrawal rate is unsustainable using low-risk investments in a low interest rate environment.

The first commonly used approach is to make a large a shift from stock to fixed income immediately at retirement. Many like this approach because it allows their portfolio to stay aggressive all the way until retirement. It also conceptually makes good sense. I’m employed, so I can take more risk, now I’m retired, so I need to decrease my risk. However, this approach is extremely risky. What happens if there is a large market drop, or extended decline the year before you’re retired? You won’t be able to fund your retirement because suffered an immediate loss right before you needed to use that money. Remember, if your assets decline by 20%, you need a 40% return to be back to where you were. In other words, losses hurt more than the equivalent amount of gain. So, this approach can work well, but takes unnecessary risk.

Glide Path

A far better option is to use a “glide path” approach. The following example shows a glide path for an aggressive 40-year-old investor, with 25 years until retirement. Every few years, they revaluate their portfolio and slightly decrease their risk by adjusting their stock: fixed income ratio.

Should this be done every year? Probably not, but I recommend everybody re-assess their risk tolerance and allocations every few years at least. Probably once every 5 years in your 40’s, every 3 years in your 50’s, and every 2 years in your 60’s and above. The glide path doesn’t tell you what your risk tolerance is. Everyone will have a different starting allocation depending on their interests, goals, and tolerance for risk. The starting point can be quite different, but the path might follow a similar trajectory over time. An appropriate glide path can be a powerful tool to protect your assets and ultimately allow your family to generate and sustain the income you need to meet your retirement goals.