5 Years From Retirement Asset Allocation
What should your asset allocation be five years from retirement?
Should you De-Risk your portfolio for retirement? What does a good pre-retirement glidepath look like? Five years from retirement, let’s consider your asset allocation.
What does an ideal pre-retirement glidepath look like to get your portfolio retirement ready for retirement?
How are Target Date Funds 5 Years from Retirement?
Target date funds start de-risking about 25 years before retirement. What is their asset allocation five years from retirement?
For instance, look at Vanguard’s model target date fund above. This is an example of a pre-retirement glidepath. They start de-risking at age 40 for a planned retirement at age 65!
International and US equities decrease steadily over 25 years as bond allocation increases. Five years before retirement, add short-term TIPS. Note the change in asset allocation five years from retirement.
Does the average investor want to de-risk a portfolio 25 years before retirement? This seems excessive to me. Given that stocks win out over bonds during most 10-year periods, aren’t target-date funds leaving a lot of returns on the portfolio by this gradual decrease in stocks over decades?
When Should You De-Risk Before Retirement?
We’ve seen above that Vanguard starts de-risking 25 years before retirement, and the bond tent has a 40-year transition. What should your asset allocation be five years from retirement?
When should you increase bond allocation- that is- when should you de-risk before retirement??
Adding bonds means giving up potential returns in the long run. Why do you have bonds in your portfolio?
Good Question! Bonds are volatility dampeners. That’s it. That’s the whole story for the time being. Bonds are not for income; they are to mitigate against sequence of return risk by decreasing volatility in the portfolio. You have bonds, so you never sell low.
Sequence of returns risk is the largest risk facing pre-retirees today. Sequence risk describes permanent negative effects on your long-term net worth if you withdraw from a down portfolio.
The withdrawing part is key. This is why you have bonds in your portfolio: if you need to withdraw money during a sequence of subpar returns. When is sequence risk at its very worst?
Sequence of Returns Risk 5 Years From Retirement
In Figure 2, you retire at year 30. Before this, you can see how a significant negative market event affects your portfolio long-term. That is, each year, what is the risk that a negative market can cause sequence of returns risk?
Twenty-five years before retirement (year 5 of the graph), you see very little explanatory power of a negative market causing sequence risk. This slowly but steadily increases over time until the year you retire.
In year 30 (the year you retire in the graph above), the explanatory power jumps by 3.3 times! Yes, sequence of return risk is most significant the year you retire and start withdrawing from your account.
Here, we are not focusing on the “tail” risk once you retire, but rather the risk BEFORE you retire. Looking at Figure 2, the risk in the five years before retirement is not insignificant, and there is risk for even the decade before that!
Mitigating Pre-Retirement Sequence of Return Risk
As an aside, it is challenging to study pre-retirement sequence of return risk.
Please stick with me here for a second.
If I’m trying to study WHEN you should de-risk your portfolio before retirement, the only data point of significance is WHEN the market drop happens. The best time to de-risk your portfolio is right before a significant market correction, and you are always better off taking lots of risk until right before the correction happens.
So, since we are looking at the left part of the graph in real-time rather than in the future, as with the tail, it is hard to nail down a way to study de-risking. The only question, and the one that no one ever can answer, is when is the market crash?
That said, I note that those in the accumulation phase and in retirement (who have adequately mitigated sequence of returns risk) have NO Market Risk. This is a bit controversial, I know.
Only in pre-retirement do you have market risk.
When to De-Risk a Portfolio Pre-Retirement
So, when should you de-risk your portfolio pre-retirement? I suggest 5-10 years before retirement.
Risk is highest the year before you de-risk your portfolio and increases real-time every year you don’t de-risk.
How to Set Asset Allocation 5 Years From Retirement
Morningstar talks a little about HOW to de-risk the portfolio for retirement.
The idea here: know your accumulation asset allocation and understand your target pre-retirement asset allocation. Then, over time, increase the fixed income/bond allocation to get to the target allocation.
You can do this all at once: selling equities and buying fixed income. Or, you can do this over time through rebalancing. Or, stop re-investing dividends and instead re-balance into fixed income.
Another way to de-risk your portfolio over time is to change the investments with your new money. Although one should almost always dollar cost average new money into equities, buy fixed-income assets rather than stocks during your transition phase.
There are many ways to skin this cat, and substance beats form when de-risking the portfolio before retirement.
A more challenging question is, of course, what should your asset allocation be when you de-risk?
How Much Should You De-Risk before Retirement?
How much you should de-risk before retirement is a very individualized issue. Asset allocation is the first true decision that an investor makes after deciding to invest in the first place.
Ten years before retirement, you should take as much risk as balances cans and needs in accumulation mode. Not only how much risk can you tolerate, but how much risk do you need to reach your goals? The usual pre-de-risking asset allocation ranges from 60/40 to 100/0 stocks to bonds.
What should your asset allocation be five years from retirement? That is:
How much should you de-risk?
Look back at Figure 1. Vanguard has a 70/30 asset allocation ten years before retirement. This then decreases to 50/50 at retirement. Next, they get even more risk-averse through retirement and decrease to 30/70 over the next ten years.
So, should you consider starting retirement somewhere between 30/70 and 40/60? It depends on your goal asset allocation and what lets you sleep at night. More commonly, a 60/40 portfolio at retirement may be adequate to protect your downside during the initial withdrawal phase of retirement.
I actually like to consider how much “safer” money you want to avoid sequence risk. Is 5 or 7 years enough? As it turns out, some might consider being much more aggressive in their asset allocation five years from retirement.
Summary- Asset Allocation 5 Years From Retirement
De-risking your portfolio in preparation for retirement is essential.
De-risking includes preparing for sequence of returns risk. I suggest you consider de-risking your portfolio 5-10 years before retirement.
Specifically, between 5-10 years before retirement, decrease from your accumulation asset allocation to your retirement asset allocation. These are personal decisions, but if one went from 80/20 (or higher) down to 60/40 (or lower), you would not be seen as having three heads.
Of course, if you have enough other sources of income and don’t need to make withdrawals on your portfolio, no de-risking is necessary.
Conversely, if you don’t fear sequence risk or think you can ride out short-term downturns in the economy, you will also be less apt to de-risk.
At least now you have some suggestions on what to do if you decide to do it.
Let’s talk about how you personalize your glidepath and understand your asset allocation five years from retirement.
How to Personalize your Asset Allocation 5 Years From Retirement
A personalized glidepath to de-risk your portfolio is an essential consideration before retirement. You will need some of your money soon to pay the bills!
Volatility (market risk) is acceptable when you are young. It is an expected part of investing. You can take more equity risk when you are young, but at some point, it is wise to de-risk your investments as your time horizon shrinks. So is it time to take some of your chips off the table?
But how should you de-risk? Generalized information is not valuable for you!
Let’s consider what a personalized glidepath might look like for you! This will take you (and your asset allocation) from accumulation to pre-retirement through retirement.
A Personalized Glidepath Depends on You!
First off, let’s state that this information is for those who have oversaved for retirement. If you have underfunded retirement, optimizing social security is the primary consideration and the major retirement decision.
If you have oversaved, let’s start with the following quote from William Bernstein, MD:
When you have won the game, stop taking risk with the money you need.
His original quote did not include the part in bold, but I (albeit in a minor way) helped convince him that he needed to add the last part to be true to the purpose of money. If part of your money is not for you or your retirement (because you oversaved—what are you going to do with the money when you are done with it?), you may be investing with a longer time horizon for your kids or charity. Different goals, different asset allocations! But one retirement.
So, often it comes down to this: how well do you want to sleep at night vs. how rich do you want your kids to be?
We each have different goals for our portfolio, which leads to personalized asset allocations five years from retirement. This is not a target date fund glidepath, which shouldn’t be used in retirement anyway.
Next, a pre-requisite to understanding your personalized glidepath is to realize that risks change as you get closer to retirement. Risks vary, and so should your asset allocation. We are not talking about market timing; we are talking about a programmatic change in your asset allocation due to a change in risk.
Risk and Your Personalized Retirement Glidepath
Aside from having oversaved, different strokes are for different folks regarding risk. We all have a distinct ability to tolerate market volatility (which, again, is a feature, not a bug of investing, and what provides the equity risk premium). What type of investor are you?
Suppose you are comfortable with a total return approach. You understand that stock market volatility at the wrongs time (sequence of returns risk) is your most significant risk and needs to be mitigated by having a store of “safer money.” Of course, some folks might have other ways to mitigate sequence of returns risk, but the primary way people who believe in total returns do so is with bonds, bond-alternatives, and cash.
Some like a bucket approach if they want to lock in time segments of their assets depending on when they need them. This, essentially, is matching your assets with future liabilities. I will need X amount for the next three years, Y amount for years 3-10, etc. A bucket plan can, of course, collapse into an overall asset allocation, but mental accounting is a practical behavioral finance intervention for some.
Others (often called “safety-first”) prefer insurance products and the guaranteed income approach.
The idea is that everyone can come out ahead by pooling your risk with others (if the thing you are insuring against actually happens). For instance, if you are worried about longevity, purchasing longevity insurance with annuities makes a lot of sense. Indeed, academically, you come out ahead mathematically if you take some of your bonds and buy a good annuity (which includes risk pooling and mortality credits).
Risk and Asset Allocation 5 Years from Retirement
While there are many ways to skin the retirement cat, five years from retirement, you have some of your assets in stocks and bonds, and you have decided to decrease your overall asset allocation before retirement to take less risk with the money you may need soon.
Regardless of annuities, buckets, or other planning tricks, you need to take asset allocation into account for part of your spending needs.
For convenience, most of the discussion below focuses on the total return approach, but you can easily apply it to buckets or safety first. You have to back out the income provided and figure out your actual withdrawal rate, which is how much money you need to spend, which you are subject to sequence of returns risk.
So, with that said, let’s get started. How much money do you need to retire?
How Much Money Do You Need to Retire
If you have oversaved, it is pretty simple to back into the amount of money you need to retire. It is easiest to think of this amount in terms of a withdrawal rate. Since you have more than you need, you need to figure out how much you need in safer money rather than the total amount you “need.”
What you do: take your yearly desired before-tax income, and subtract out your sources of income (such as social security, annuities, and possibly a part of other incomes like rentals). This gives you the amount leftover you need to fund from portfolio withdrawals. It’s a little tricky to do with before-tax money, but, after all, you do have a retirement plan in place, right?
Take the money you need every year and divide that by your nest egg. This results in a withdrawal rate on your overall portfolio.
So, say you need 200k, and you have 100k in other income sources. You need to support 100k worth of withdrawals from your portfolio. If you have $5M, your withdrawal rate is 2%. [100k/5,000k = 0.2] That’s the amount you need to withdraw from your portfolio every year to meet your spending goals when you retire.
Next, how many years do you need to support those withdrawals?
How Many Years?
This question is critical. How many years of safer money do you need to avoid the bulk of sequence of returns risk?
We are using a total return approach with stocks and bonds. Most years, stocks go up, and we have more money at the end of the year than initially. However, we must plan for a poor sequence of returns just as we retire, as that is the major risk in early retirement.
This is important: you need to decide how many years of “safer money” to have on hand before you retire. For example, how many years’ worth of withdrawals should you have in non-equity investments? This is money that you can tap if the market misbehaves.
To address the question “how much safer money do I need,” you need to understand two ideas: 1) how bad will sequence of returns risk be this year if it happens, and 2) how long do downturns last.
How Bad will Sequence of Returns Risk be THIS YEAR if it Happens
Look back at figure 2 again. Again, you can see how likely sequence risk is to hurt you depending on when you plan to retire.
The year you retire, there is a massive spike in the explanatory power for each year’s returns. As a result, you are most vulnerable the year you switch from paychecks to portfolio withdrawals.
But the pre-retirement risk is not zero! Note that the risk slowly increases as you get closer to the retirement date. Of course, if you are still 10-20 years from retirement, you have a lot of human capital and flexibility to make changes.
However, once you have pulled the plug and are living off your portfolio, the effect of a poor market is enormous for the first five or so years.
So, in summary, you probably need 5-10 years of safer money both before and after retirement.
This is the time of maximal risk for a poor sequence of stock market returns.
But one of the ways we mitigate sequence of returns risk is with a more conservative portfolio. If the stock market crashes, we expect our bonds to dampen the volatility and perhaps even increase value due to flight-to-safety. You have never to sell your equities when they are down and give them time to recover. Even if sequence risk happens, how long might it last?
How Long Does a Downturn Last?
As it turns out, the length of a downturn depends on your asset allocation!
If you are 100% equities, you can have a “lost decade” like the 2000s, where equity returns are negative. However, a more balanced portfolio should have a shorter period of rebound.
Let’s look at a cut-out from the Merriman’s Fine Tuning tables.
Above, see returns for the worst year and rolling 3- and 5-year periods. These returns are shown with different asset allocations.
On the left, 100% bonds. On the right, 100% stocks. In the middle, 50/50, with 30/70 to the left and 70/30 to the right.
So, at least with historical rolling returns, if you are 50/50, you might be down 6.8% at three years and 2.1% at five years.
Another way to think about it: at five years out, you have to be 30/70 to (historically at least) avoid a negative 5-year period. Is that important to you? Maybe, maybe not!
The point here isn’t to die by decimal places; it is to understand the length and depth of your portfolio’s decline is tied to the asset allocation.
At least as determined by how long your portfolio might be down during a bad sequence, risk is defined by your asset allocation.
Now that we know how many years of safer money you want, let’s calculate your asset allocation.
How Much “Safer Money” Do You Need?
Let’s just cut to the chase. You need 5-10 years of safer money, or even more if you want. Remember, after all, that the upside is that the kids get rich.
You lose some sleep in year 3 or 4 (or more!) of depression and stock market crash. This can be heart-wrenching; it may feel like the world is ending, but remember, you still have plenty of money to retire.
Because, fundamentally, you are in the 90 (or even 99th) percentile of retirement savers out there. If the world crashes and burns, 90% of America will crash and burn before you do. That is a world that I’m not even going to consider here.
So, take your years and your withdrawal rate and multiply them to get how much safer money you need.
Actual Asset Allocation of Safer Money
Ok, so let’s get into some nuts and bolts of safer money. I talk specifically about this in Equity-Alternatives in Your Asset Allocation Equation.
Say you want ten years of “safer money.” If we want ten years x 2% = 20% of the money in safer assets, then our goal asset allocation depends on how much is in the portfolio.
If we have $5M, our goal is 80/20 when we retire. How does your personalized glidepath work? About ten years before you retire, glide from your 90/10 down to 80/20.
This means, for example, eight years before retirement, you will still have eight years and will have moved two years from “risky” to “safer” money. That keeps a 10-year buffer spread over the pre-retirement glidepath. Five years before, you will have half your money in safer assets and still have five years to go.
Remember, 80/20 sounds risky (compared to a “traditional” retirement portfolio), but you have ten years of safer money. And this doesn’t even include the dividends! I will gloss over this point, but you should be taking your dividends when you retire as part of your income to spend. We are talking about total return investing, not dividend investing. Don’t invest for dividends, as that increases your risk.
There is, as always, a chance that a terrible market might cause you to sell some equities at a loss, but your safer money mitigates this possibility.
Think about the “traditional” 60/40 portfolio for a “traditional” retiree. You have a 4% withdrawal rate and ten years of safer money, which is 4 x 10 = 40%. So the traditional 60/40 has ten years of safer money just like your 80/20 has because your withdrawal rate is lower.
Again, the balance is how well you sleep at night vs. how rich you want your kids (or charity) to be. You don’t have to take the risk. You could liability match in a TIPs or I-Bond ladder and be fine. You could annuitize a significant chunk of your bond allocation and do great. There are many other ways to take risk off the table if that is your desire.
How Long do you Keep your “Safer Money” Once Retired
I have a separate blog, Should you Rebalance your Portfolio After Retirement, that addresses how long you should keep your “Safer Money” around in Retirement.
The critical understanding revolves around the portfolio size effect. This is retirement risk before retirement and sequence of returns risk after retirement. I review the data on rebalancing in retirement, and you can decide for yourself how long to keep your safer money once retired after reading that blog.
However, remember once you get into your 80s, that sequence of returns risk is affected by RMDs. Your withdrawal percentage will increase as RMDs increase. If you are taking out more money than you need, there are after-tax considerations I cover in my blog RMD Asset Allocation and Safe Money.
Summary—Your Personalized Asset Allocation 5 Years From Retirement
In summary, how much risk are you willing to take to keep an “aggressive” asset allocation five years from retirement? If the risk is a sequence of returns risk (and it is), remember to mitigate the risk by having safer money you can spend while the sequence passes.
And once the sequence is done, it might be time to increase your asset allocation with event-based rebalancing (see the additional blog references above), but then watch out for the sequence risk due to RMDs!
You are allowed to change your asset allocation programmatically. This is not market timing! Using information about your needs (your expenses and projected withdrawal rate) and understanding that what goes down must come up, you can better optimize an asset allocation beyond the traditional 60/40.
Remember, sequence of returns risk is elevated even before retirement, so the time to take money off the table is when you have money to take off the table. If you knew when the market would crash, of course, you’d stay aggressively invested until then. But we know you cannot time the market, so stop taking risks with the money you need.
Finally, “there is no risk in the past,” as Paul Merriman says. It is only for now that you can plan. Set your asset allocation for the bad times, not for the excellent time. You can programmatically change your asset allocation via a personalized glidepath. You have more control over the bad times than you think. That is the benefit of oversaving.