Every investor has an asset allocation within his or her investment portfolio, whether intentional or not. This basically describes how the invested funds are divided among various asset classes — broadly, stocks, bonds and cash. An investor’s asset allocation is designed to help manage risk and work toward certain performance goals.
A sample allocation might be a 50/50 allocation: 50 percent invested in stocks and 50 percent invested in bonds. Within this allocation, funds may be categorized into domestic or international stocks, and subdivided further into large, medium or small capitalization companies, or growth and value-oriented equities. The following pie chart illustrates how a sample strategic asset allocation might break down.
Because stocks tend to be more volatile, the typical advice in the past was to move money predominantly into cash and fixed income holdings as an investor approached retirement.
In fact, one potential recommendation would be to determine an investor’s asset allocation by his or her age. Specifically, subtract the investor’s age from 100 to determine the percentage of his or her portfolio that should be invested in stocks. For example, under this scenario, a 30-year-old would invest 70 percent of his or her portfolio in stocks. By the time the investor turned age 70, the stock allocation would be reduced to 30 percent.
However, today’s investors face a different set of circumstances from previous generations. There is the concern that Social Security will become underfunded in the future and forced to reduce benefits. Furthermore, fewer companies offer pension plans to retirees, so workers must diligently save on their own to provide retirement income.
Perhaps the biggest threat to income security during retirement is that people are living longer than ever. This means they may need to adjust their asset allocation more slowly than in the past. Instead of moving assets to more conservative holdings before or at retirement, they may want to keep a substantial allocation in equities throughout their 60s and even 70s. After all, if an investor (and/or spouse) lives to 90 and beyond, he or she may need this portfolio to continue growing to provide income throughout his or her lifetime.
In addition, the impact of inflation over three decades of retirement can create a higher cost of living. And finally, people who live longer may incur more health care expenses, so their income needs to stretch even further to help cover these costs.
“It’s good to use 30 years of retirement as a general guideline. And when you are making projections, you should always err on the conservative side — maybe even going all the way to 100 or 110.”
While investors may spend most of their time thinking about performance returns, retirees are generally more focused on income. Stock market returns are prone to move up and down, but that’s the last thing retirees want to experience with their household budget.
That’s why it may be important for retirees to consider different ways to diversify their asset allocation to include growth opportunity, steady sources of regular income and even the potential for income growth among those payout streams.
To help minimize volatility within a portfolio, it may be worth considering investments that provide income regardless of share price fluctuation, such as dividend stocks. These stocks are generally offered by well-established companies in low-growth sectors such as utilities, energy, telecom and real estate. Dividend stocks typically offer reasonably high yields and tend to increase shareholder payouts over time.
Another option may be to reposition a portion of assets to provide a guaranteed stream of income by purchasing an income annuity. There are a wide variety of annuity types depending on investor need, and all guarantees are backed by the issuing company. In fact, indexed and variable annuities are two types that provide the opportunity for income growth throughout retirement.
Another consideration for retirement allocations is the mix of taxable, tax-deferred and tax-free investments. It may be a good idea to diversify portfolio allocations across these options so that all of your retirement income is not taxable, which could push you into a higher tax bracket.
Bear in mind that although a general portfolio of stocks and bonds is taxable, investments made through a traditional IRA or employer-sponsored retirement plan are tax-deferred. Both of these allocations will contribute to your tax bill when you withdraw funds during retirement. Even if you don’t need the money, tax-deferred accounts will require you to withdraw a certain minimum amount each year after age 70½, and those distributions will be taxable.
Therefore, it may be worth considering placing some of your retirement assets in tax-free accounts. One such investment is the Roth IRA, in which withdrawals, including earnings, are generally tax-free in retirement.
Another option is to maximize contributions to a Health Savings Account (HSA) if one is available as part of your health insurance options while you’re still working. Interest on money within an HSA grows tax-free. Withdrawals made to pay for qualified medical expenses are tax-free, and after age 65, withdrawals made for any reason other than medical expenses — even just regular household income — will not incur a 20 percent penalty tax but will still be considered taxable income. And unlike a tax-deferred account, there are no required minimum distributions as you age, so interest can continue compounding tax-free.
By diversifying your retirement asset allocation across a variety of accounts, you can optimize the tax efficiency of your overall portfolio. According to an analysis conducted by Morningstar, a well-executed tax allocation strategy can boost your bottom line each year by as much as a half-percent. In dollar terms, that’s $500 a year for every $100,000 invested.
Strategic Allocation Adjustments
Some people follow the traditional advice and transfer investments to more conservative holdings when they retire. Others don’t bother; they maintain the same equity-rich allocation throughout retirement in hopes of ramping up gains, making up for previous losses, or maybe they just don’t bother to make changes at all.
Given the challenges of today’s longer-living seniors, it’s a good idea to work with a financial advisor to develop a pre-retirement asset allocation strategy. But the work doesn’t end there. Once you retire, you should continue to monitor your portfolio’s performance and adjust the allocation periodically to reflect your age, health status and income needs.
Over time, you may want to transfer investments to a more conservative allocation. However, it’s important to do this strategically. For example, use periodic rebalancing opportunities to evolve your allocation.
One reason it may be helpful to make these allocation decisions with a financial advisor is that there may come a time when you are less interested in your portfolio and/or incapable of making allocation decisions on your own. If you are the primary investment manager in your household, these may not be decisions your spouse can take over. It’s important to appoint someone fairly early in the process to be your proxy in this situation, whether it’s your trusted investment advisor or perhaps an informed family member.
The key is to make this decision while you still can, for the sake of loved ones and maintaining the household income. After all, when we get to the point where we’re no longer able to make investment allocation decisions, we may be at the point that we don’t even realize it.