How To Design And Customize Your Retirement Asset Allocation Framework
The one-size-fits-all approach their advisor may have used during the accumulation phase just won’t work when it’s time to retire.-George Politarhos
Generic, templated approaches to financial planning can work for some people during the “accumulation” phase of their financial lives. However, as a person gets within five to seven years of retirement, it becomes obvious that “one-size-fits-most” recommendations fall far short of the mark. That’s because retirees differ from one another in their goals, risk, tolerances, and the cash-flow demands they will make on their portfolios.
For example, if you are one of the lucky few who receives a government or corporate pension, you might be comfortable with a more aggressive position in stocks, perhaps even more than 50%.
Your neighbor, on the other hand, might have a shorter time horizon and believe he’ll spend his entire portfolio during his lifetime. That means he’ll need more liquidity and less volatility in order to avoid running out of money in retirement. In this scenario, a person risks having to pull cash out just when riskier assets are in a downward spiral. For those within a few years of retirement, it is critical for you and your income and retirement specialist to draw up a customized framework for your asset allocation. Below are some steps to drawing up your asset allocation “map.”
Estimate retirement expenses
A retirement “rule of thumb” is to expect your expenses in retirement to be about 20% less than they were while you worked. This is not always the case, though. If you were a diligent saver during your working years, it’s possible you could get by on 75%, even less, of the income you made while working. Conversely, if you did a poor job of saving, or encounter unforeseen medical issues or other emergencies, you may find you need much more than 75%. Your map, then, cannot be set up and then forgotten. Variations in lifestyle goals, needs, and risk tolerance, all need to be considered and included in updates to your expense estimates. Your map must also include the amount of expenses that your income sources, such as pensions and Social Security, will cover. Subtract those income sources from spending needs and you will come up with the amount of money your portfolio must generate.
- Withdrawal rate- don’t think 4% is written in stone
Many advisors recommend withdrawing around 4% of your portfolio to meet needs in retirement. If you divide your annual spending by the value of your total portfolio, you can get an idea of whether or not the 4% “rule” makes sense in your situation. For example, say you have a portfolio worth $2 million. You determine you will need $50,000 to live on after you stop working. In your case, a 4% withdrawal might make sense. Those with smaller portfolios and fewer income streams may want to rethink the 4% rule, especially given market volatility and low bond yields.
- How much in liquid assets do you need?
Once you have determined if your withdrawal rate is sustainable, it’s time to set up your portfolio according to your spending horizon.
Again, every retiree’s situation is unique. A conservative approach is to have two years’ worth of cash on hand for your spending needs. This is not your emergency money, but rather liquidity that you need to offset market downturns, for making large purchases, paying off debt, etc. Some retirees, especially those who have been able to save, may feel comfortable having as little as six months’ of cash.
Predict your emergency needs. No matter how carefully one plans, things happen. The wind rips off a patch of shingles, the plumbing backs up, or your car breaks down. Having an emergency fund, especially one where every dollar is actually working for you, will provide you with unprecedented peace of mind when the paychecks stop coming in. Maintaining a separate emergency fund will help you cushion the blows from unforeseen circumstances. Best of all, there are ways to enhance your emergency fund using specific, specially-designed financial products that allow you to grow your emergency fund.
- Safe money investments
There is an “opportunity cost” if you have too much in cash, so you want to ensure that your portfolio doesn’t have a penny in lazy money. If you avoid risk too aggressively, you run the risk of having your money eaten up by inflation over the typical fifteen to twenty-five year time horizon of a typical retiree. Inflation, which isn’t so impactful in a two-year time period, can significantly erode a retiree’s purchasing power over a ten year or longer period. In spite of current low yields, bonds are a popular choice for many seniors. Annuities, particularly fixed indexed annuities, and life insurance are also useful in creating streams of income and hedging against inflation. There are hundreds of options when it comes to these kinds of products, so it’s a good idea to engage a retirement and income specialist to help you navigate the maze.
- Discover how much you want to invest in higher-risk assets
Once you’ve carved out funds for emergencies, liquidity, and safe money, the remainder of your portfolio could go into other assets. Following guidance from your advisor, you could put money into cash-flowing assets, such as rental properties, precious metals, REITs, stocks, or emerging-market bonds. For this step, in particular, you want to take all circumstances, including your own mindset about money, into account. If you worry constantly about outliving your money, for instance, you might want to dial back risk significantly and hold more in cash and safe money instruments. If you have a longer time horizon, or if your priorities include leaving legacies for loved ones, your approach should incorporate those circumstances.
Setting an asset allocation for your retirement portfolio is a necessary component of creating a better quality of life when you no longer work. This is the first step you and your advisor can take to make your money last longer in retirement, and reduce the need to make drastic lifestyle changes.
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