Investing during retirement is entirely different than investing for retirement. Different strategies are required for the accumulation and distribution phases. During the accumulation phase, it may be appropriate to take moderate risks in return for the prospects of higher returns. A young person with a very long time horizon until retirement and a high risk tolerance might invest her entire portfolio in stocks. During retirement, a much more conservative portfolio is generally called for. That's because the requirement to generate periodic withdrawals to produce income introduces a risk that the portfolio might self-liquidate.
Investing during retirement is entirely different than investing for retirement. Different strategies are required for the accumulation and distribution phases.
During the accumulation phase, it may be appropriate to take moderate risks in return for the prospects of higher returns. A young person with a very long time horizon until retirement and a high risk tolerance might invest her entire portfolio in stocks.
During retirement, a much more conservative portfolio is generally called for. That’s because the requirement to generate periodic withdrawals to produce income introduces a risk that the portfolio might self-liquidate. Generally speaking, a retirement portfolio should be very heavily weighted in short term bonds. Short term bonds provide a store of value and reduce the risk for the portfolio. Both are important to retirees.
A generous cushion of bonds provides a ready source of funds for distribution without regard to market fluctuations. We believe that retirees should determine their total income needs for the next 7 to 10 years and allocate enough bonds to cover at least that amount. For instance, a retiree that expected to withdraw 4% of his nest egg each year would want to hold at least 28% to 40% in bonds. With that cushion established, the retiree can withdraw for a very long time without being forced to liquidate his more volatile stocks during a possible down market. It’s important to preserve those volatile but high return growth assets for future recovery.
A low-risk, low-volatility portfolio generally provides a higher probability of success during the withdrawal phase than a more volatile portfolio. Here we define success as not running out of money while alive. While bonds may not earn as much as stocks over the long run, they serve to greatly reduce the portfolio risk.
It would be a mistake to wait until the last possible moment to change strategies from accumulation to distribution. After all, you wouldn’t want your retirement tomorrow dependent on what the market did today. If you are not properly positioned in advance, a couple of bad years in the market might set your retirement date back a decade or more. An orderly migration strategy from accumulation to distribution strategies insures that you won’t be hung out to dry if the market turns south.
It might make sense to have your retirement portfolio in place a couple of years before you actually walk out the door. Then, pick a time about 7 to 10 years in advance of your desired retirement date to begin your transition. So, for example, let’s say you decided that you wanted 40% of your portfolio in bonds when you retire, want the portfolio set up 2 years before the actual date, and want to start 10 years before retirement to begin to adjust the portfolio. Your portfolio today is 100% stocks.
You have an 8-year transition period. So, beginning 10 years before retirement, move 5% of the portfolio each year to short term bonds. Two years before retirement you will have your 40% in bonds and can look forward confidently to retirement without worrying too much about what the market does.
Of course, if stocks earn more than bonds during the transition period, you will have a somewhat smaller nest egg. Economists call that potential underperformance an “opportunity cost.” But, you will have greatly reduced the chance that a possible market crash will leave you unable to retire at all. So, the opportunity cost may be a small price to pay for peace of mind.
An investment strategy isn’t necessarily about maximizing returns while ignoring risk. Most often the appropriate strategy is the one that will maximize the probability of a successful outcome. That requires considering both risk and return. Migrating early to your preferred retirement portfolio greatly increases your chance of a successful retirement experience.
By Frank Armstrong III, CFP, AIFA
Frank Armstrong III is founder and CEO of Investor Solutions, Inc., an independent, fee-only investment management firm in Coconut Grove, Florida () The firm has been named on Bloomberg’s list of Top Wealth Managers, rated a “Five Star” on the Paladin Registry, and selected by Barron’s as one of the top “100 Best” Independent Financial Advisors in the country. Frank has more than 35 years experience in the securities and financial service industry. He contributes to major publications and appears regularly on television and radio. He is the author of the forthcoming book, SINK OR SWIM: Enjoy a Successful Retirement in an Age of Cradle-to-Grave Insecurity and the bestseller, THE INFORMED INVESTOR: A Hype-Free Guide to Constructing a Sound Financial Portfolio.