One of the most common rules of thumb and one that I often see written even by other financial professionals is that as a person approaches retirement the risk level of portfolios should decrease. Clients ask about this very regularly too, as they read some of the same things I do. Target date funds have become pervasive in 401(k) type plans – using them is convenient because they automatically reduce risk by lowering stock allocation as you approach the date.
But is this what you should be doing? It’s not as clear as it’s made to appear and as you may think. The risk a client takes on any investment should be function of two main factors.
One of them is pretty straightforward and it is your willingness to take risk at all. Choosing your risk level is like picking a point on a continuum. Picture an XY axis with annual volatility on one axis and long term returns on the other. You could draw a curve on this chart that indicates a positive correlation between the two. On one extreme is very low annual volatility (variability of returns, picture cash) and low long-term return. The other extreme is very high volatility (up and down, picture stocks in any year) but high long term return potential. You could draw a curve (not a line) connecting these points and then as an investor you need to pick a point on that curve you are comfortable with. There’s no right answer, it’s based on your stomach.
The second and more quantitative factor is the timing of when you need your money and how much you need relative to what you have. For instance, if you need 100% of an investment in 2 years for something finite like college or a home down payment, etc. it should likely be in a low risk/low return investment because you can’t afford to lose it and markets are unpredictable in the short term.
Retirement planning is different. People tend to think of it as finite, as a finish line – you need to be conservative now because you have reached a certain age. But think about it – this isn’t a lump sum purchase. This is a goal of yours that may last 30 years or more, it’s not a finish line at all. And you could make an argument that the bigger mistake that people make is becoming too conservative too early and risking their ability to keep up with long term inflation.
In one example, a client with $2 million at retirement has an $80,000 level of expenses, no pension and a mortgage that will still exist for the next 12 years.
In the second example, the client with $1 million has a$50,000 level of expenses, a $40,000 pension and no mortgage at all. I’m ignoring social security for this illustration because it could be equal in either, but that would play a part.
In the first example, that $80,000 expense level requires a4% payout rate on assets ($80K/$2 million), plus the mortgage payment for the first 12 years. This client, no matter how they feel about risk/reward, has limited options in terms of the risk that they take because they need to generate substantial payout relative to what they have. Any portfolio that has a high payout rate can’t be too aggressive because they really can’t afford that negative year, which we know will come many times over the next 30 years.
The second client only needs $10,000 annually from their $1million. That’s a 1% payout rate which makes a huge difference. This client can afford the year-to-year volatility because the payout rate is low, and if they choose to they can assume more risk in search of potential long-term returns. This client should not necessarily get more conservative as they approach retirement, because they should be prioritizing long term returns to keep up with inflation.
While 4% isn’t a rule (discussed in another article) you can use it as a guide. Trying to accumulate enough and manage expenses to a level so that you do not need a 4% payout rate on your assets is a key to giving yourself investment choices in retirement. There is of course irony in the idea that putting yourself in a position where you require less of your money for living expenses allows you to take on investment risk and earn more long term returns that you don’t need, while the client that needs the high payout rate has to settle for more stability and lower long-term returns. But that’s the reality.
The key is to plan ahead and know the situation you are in as you approach retirement, and that will help you with determining how you should approach risk as you approach that date. It also may help you determine retirement timing. If working 3 more years allows you to accumulate additional assets that lower the eventual payout rate, you may choose to prioritize that investment flexibility over retirement timing. These are the things we help clients with each day.
Together, we can work to keep you on-track towards your financial goals.
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Read more articles by Lance R Hoenig