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Ready to Retire? How to Properly Frame the Investment Allocation Conversation Thumbnail

Ready to Retire? How to Properly Frame the Investment Allocation Conversation

Young investors are often told to embrace risk in their portfolios. The ups and downs of the markets are an ally in the pursuit of long-term growth, and losses only matter when they’re realized. Rarely is this common and often correct advice applied to investors that are nearing retirement. But indeed it should. Not because sixty is the new forty, but because investment allocation decisions should be based on when the invested funds will be needed, not on how old you happen to be.

The happy fact is that people nearing retirement often have a long time horizon ahead. The challenge is in funding a long retirement, while many will begin withdrawing money from their retirement accounts shortly after they retire, the amount withdrawn as a percentage of the total portfolio can vary greatly. Pensioners, or those with a low-cost of living, may find that their guaranteed income sources satisfy most of their spending needs, while others may be far more reliant on portfolio withdrawals to meet theirs. Rather than using age to guide your investment strategy, consider something far more useful: a budget.

A budget will help identify the magnitude and frequency of portfolio withdrawals, along with those expenses that may be temporarily curtailed when necessary. In other words, it tells you the extent to which you will rely on your financial assets to satisfy your retirement spending needs and your capacity to embrace investment risk. You should also consider the types of accounts, as they may be subject to different methods and rates of taxation. Armed with your budget, a listing of assets and an inventory of your retirement income sources, it’s time to get to work on your investment allocation.

Investors that rely only minimally on portfolio withdrawals to meet ongoing spending in retirement may find that their investment time horizon is actually quite long and that their capacity for investment risk quite high. In this situation, an asset allocation focused on long-term growth could be appropriate, despite the investor’s age.  Modest portfolio withdrawals may open up additional planning opportunities, such as a Roth-IRA conversion or Qualified Charitable Distributions, which may not be as viable for those that are heavily reliant on their portfolio to provide current income.

Most investors nearing retirement will find that they need to take material and ongoing distributions from their retirement accounts. A common rule of thumb suggested that retirees invested in a balanced portfolio of 60% stocks and 40% bonds could begin withdrawing 4% of their portfolio’s value at retirement and continue these withdrawals, adjusted for inflation, for a period of up to 30 years. Updated research, however, suggests otherwise. Historically low interest rates are to blame, as is the risk posed by poor market returns early in retirement. The message to these investors is clear: a comprehensive retirement income plan, not just an asset allocation strategy is needed.

Investors have a variety of tools at their disposal. One simple way to be less reliant on your investments for retirement income is to trade some portfolio assets for a guaranteed income annuity. These come in many varieties- those near retirement should focus on annuities that offer a high-level of income that is not directly correlated to the performance of equity markets. A Qualified Longevity Annuity Contract (QLAC) that defers income until later in retirement may be used to provide an income top-off later in life.

Older investors may also wish to create specific investment allocations that are matched to immediate and long-term spending needs. This so called bucket approach, seeks to divide assets into a safe bucket that will be used to fund near-term income and a riskier bucket(s) that is invested for growth. Investors would deploy assets in their safe bucket to less volatile asset classes and those that produce high levels of current income. Investments that are earmarked for future spending could be allocated to a diversified portfolio of stocks that focuses primarily on growth. Over time, the short term bucket can be refilled by selling those investments in the long-term bucket that have performed well. This approach provides protection from poor investment returns early in retirement (think of those that retired in 2008), and has the added benefit of clearly delineating the sources of retirement income.

Investors nearing retirement should focus less on their chronological age and more on their retirement income needs and capacity to embrace risk. An integrated strategy that considers spending needs and matches income sources and investment allocation with spending needs can help increase peace of mind and keep investors on course.