Asset Allocation During the Drawdown Phase of Retirement
What should your asset allocation be during the drawdown phase of retirement?
You are actually living off your assets, taking an income from your nest egg.
Like most traditional DIY investors, you have had an asset allocation for your entire investing career. Should that asset allocation change now that you are in the drawdown phase, also known as the retirement withdrawal or distribution phase? This is a more theoretical discussion. See Asset Allocation Five Years from Retirement if you want an actual number.
Let’s discuss asset allocation during the drawdown phase of retirement. Like asset allocation in accumulation, it is not a simple answer. Or rather, unlike asset allocation in accumulation, you don’t hear many people actually consider anything beyond an ultra-conservative 30/70 type of portfolio like you see in target-date funds.
First, I want to start just with the numbers during Required Minimum Distributions (RMDs). Some folks must take RMDs even if they don’t need them. If we look just at RMDs, how does that inform our asset allocation in the drawdown phase?
RMD Asset Allocation Strategy
Even if you have oversaved for retirement, once RMDs (Required Minimum Distributions) begin, you must start withdrawals from your pre-tax retirement accounts every year.
What should your asset allocation be given these unnecessary RMDs? This is an important consideration, as most gloss over this topic or suggest 50/50, or 30/70, or the like.
But what if we decide first how much “Safer Money” we need just to take out the RMDs? After all, we don’t need the money. Then, how aggressively can you invest (asset allocation strategy) for unneeded RMDs?
Asset Allocation for RMDs
How aggressive can our asset allocation be in an IRA when we know unnecessary RMDs are coming?
Do you want to avoid selling equities when they are down? For example, if the market has crashed and you have to take your RMD, it might be nice to have some “Safer Money” you can withdraw instead of selling stocks. Yes, technically, since money is fungible, you can just buy back those stocks you sold “at a loss” in your IRA in a brokerage account. But I still just don’t like to sell low. Sort of like the bucketing approach to asset allocation in the distribution phase.
So, how much Safer Money do you need in your pre-tax retirement accounts (henceforward called IRAs) to prevent RMDs forcing you to sell low?
We know the market can be down for a long duration before it recovers. But, since you are forced to take distributions, what percentage of your pre-tax retirement accounts do you need in “Safer Money” (cash and bonds) to not sell equities when they are down?
I’m going to use the new RMD table below, so we might as well introduce it now.
New RMD Table in 2022
The RMD table changed in 2022. Have a look:
Above, you can see “old” and “new” RMD calculations starting at age 72. This is the uniform life table updated for 2022; most folks use it to calculate their yearly RMD percentage.
The “old” RMD factor at age 72 is 25.6, and the “new” one is 27.4. This means you used to be forced to take 3.91% of your pre-tax money at age 72, and now it is 3.65%. Not a big difference, but it is a 6.65% decrease.
The new uniform life table considers that folks are living longer, and thus “need” to withdraw at a slower pace to account for longevity. Of course, most folks take out more than their RMD every year… but those folks are not my typical audience.
Now that we know the new RMDs in 2022, let’s next discuss sequence risk and how much safer money you might want in your pre-tax retirement accounts.
Sequence Risk and RMDs
If you have oversaved for retirement, you may aggressively invest in your IRA.
While you should de-risk prior to retirement, if you don’t “need” the money, then you can invest aggressively in your 70s and 80s for your kids or charity. As I say, at that point, asset allocation concerns the tradeoffs of sleeping well at night vs making the kids rich…
That said since you are forced to take out RMDs every year (whether you want to or not), there are unique sequence risk considerations.
Usually, when we talk about Sequence of Returns Risk, we talk about the five years before and ten years after you start portfolio withdrawals in retirement.
Here, we are talking about forced pre-tax distribution due to RMDs. These are fully taxable.
If you are forced to sell equities when they are down (because you have no “Safer Money” in your IRA—after all, you are aggressively invested since you don’t need the money), then a couple of bad years might impede the overall returns.
So, if you must take out 30% of your IRA in the next couple of years, should you have at least that amount in “Safer Money,” or is it ok to be 100% stocks? How much safer money do you need from the forced RMDs, and what should your asset allocation be due to RMDs?
Let’s answer that question in a second, but first, is RMD sequence risk an issue of fungibility or taxes?
Consider the fungibility of your IRA and brokerage accounts for a second.
Wait, What About the Fungibility of Money in my IRA and Brokerage Account?
I might lose some people here, but that’s ok. Skip this section if you aren’t a nerd.
When RMDs force you to sell pre-tax equities when they are down, you cannot “just” adjust your overall asset allocation to make up for it.
Yes, money is fungible, and, actually, the inverse of the above is true. But while your brokerage account is fungible with your IRA, your IRA is not fungible with your brokerage account because of taxation.
First off: If you are forced to sell equities from your brokerage account when the market is down, you can adjust your overall asset allocation and be fine. Fungible.
As an example, think about this for a second:
You need cash from your brokerage account, but it is 100% equities (as you might see if you have a good asset location strategy). So if the market is down and you sell stocks low, aren’t you committing the cardinal sin of investing by selling low and locking in losses?
No, not really. Say you have bonds in your IRA. You can exchange some of those bonds into stocks while you sell the stocks in your brokerage account. So you have sold stocks, and then sold bonds and bought stocks. That is [(-) stocks plus (-) bonds plus (+) stocks], which works out to just selling bonds!
[The dark underbelly of fungibility is that you actually must calculate the after-tax equivalence to get your asset allocation the same as before, but that is complicated, and most don’t bother… Of course, suppose you want to bother. In that case, you might decrease your brokerage account by your capital gains rate and decrease your IRA by your effective tax rate, and then adjust your asset allocation accordingly, but then your head might explode.]
But it is not the same if you are FORCED to take RMDs instead of choosing to take money from your brokerage account.
With RMDs, if you sell stocks low but don’t need the money, you can just turn around and buy those same equities in your brokerage account with the liberated money.
The amount invested, however, actually is decreased by your marginal tax bracket (rather than effective) as, since you don’t need the money for expenses, they are the last dollars out of your IRA. Moreover, since you are practicing good asset location hygiene, you don’t have bonds just sitting around in your brokerage account that are fungible.
If I haven’t lost you by now, you are indeed smarter than me.
But the long and the short of it: Since RMDs increase over time, even if you don’t need the money, you should have more Safer Money in your IRA as you get older. This is because when you are forced to sell equities low (and then pay marginal taxes on them) only to re-invest the money in a taxable brokerage account, you will never catch up because of the taxes. Not fungible, even if we use after-tax equivalence.
I would love to hear what you think about this section if you are still with me. Are unneeded RMDs fungible? What say you?
Regardless, I hope you agree that Safer Money is needed in an IRA once RMDs commence.
The question is next: How Much?
Asset Allocation in Your IRA due to Unnecessary RMDs?
To back up for a second, we are asking the question how aggressive our asset allocation can be in our pre-tax retirement accounts. This assumes we don’t need the RMD, and that our ultimate goal is to understand our drawdown asset allocation.
So, what should your asset allocation be in your IRA due to unnecessary RMDs?
This is simple math. How much safer money do you need in your IRA because you must take RMDs? Of course, we know the amount you have to withdraw every year (it is above), but the question is: how many years might the market be down?
To answer this question, we need to know the duration of the average drawdown. So, how long do drawdowns last?
How Many Months is the Average Time to Recovery from a Drawdown?
Let’s start simple. Above, you can see the performance and length of Corrections and Bear markets.
On average, recovery from a drawdown takes 22 months—call it two years.
Let’s dig in a little more.
How Long do Bear Markets Last?
Above, you can see some bear markets are extremely short (3 months in ’87, ’90, and even shorter than that in March 2020).
We remember the 2000 and 2008 wrecks; they lasted 31 and 17 months.
This number (duration) is from top to bottom. After that, we still need to get back to breakeven!
We are interested in how long it takes for the market to recover?
How Long Does Recovery Take?
Instead of the duration, see the recovery period, above.
Remember the bear market lasted just three months in ’87 and ’90? Well, how long did it take to get back to zero? That is, how long did it take for the stock market to recover the lost value during the bear market?
You can see 19 months and five months for ’87 and ’90, respectively.
And for 2000? The bear market lasted 31 months but took 55 months (4.5 years) to recover. And in 2007, even though the bear market was shorter (17 months), it took 65 months to recover (5.4 years). The most prolonged recovery is in ’73 at 5.75 years.
So, in summary, on average, it takes about two years to recover, but it may take up to 5ish years.
And this is, remember, historical data rather than predictions about the future.
Conclusion- RMD Asset Allocation Strategy
So, in summary, you need 1, 3, or 5 years of RMDs kept as safer money to prevent you from selling equities when they are down.
One year if you are extremely aggressive and don’t want a lot of cash and bonds in your IRA. One year of safer money is, of course, easy to calculate. If equities are up when you take your RMD, just sell enough to meet your RMD and a little extra to account for the increase in RMD next year. Have one year of cash or bonds (or even long-term bonds) that slowly increases over time as your RMD increases.
If you are more moderate (and understand that this is, in toto, a super aggressive strategy to begin with), you might have three years of RMDs in Safer Money.
If you are conservative, consider five years of Safer Money.
Here is what you need: (at the stated age, three years or five years of RMDs require this percentage in safer money)
- 3y 11.36%
- 5y 19.65%
- 3y 15.53%
- 5y 27.14%
- 3y 26.16%
- 5y 46.60%
Even if you can tolerate a high equity allocation in retirement because you don’t need the money, you might want to decrease your asset allocation over time to prevent you from selling equities low.
This is the “Safer Money” in your IRA. Since you are forced to take the money out, it has a unique sequence risk as you get older. As stated with incredible perspicacity above, this is due to tax issues rather than fungibility concerns. (I’m happy to be proven incorrect on the topic.)
But beyond a point, there is a theoretical risk that you could wind up with less money if you are too aggressive in your IRA and don’t account for RMDs during a bear market.
So, we have decided that if you don’t need the RMDs, you can be pretty aggressive in your asset allocation during drawdown because all you need is the safer money.
But how aggressive should you be in your drawdown asset allocation? First, you want to make sure you understand the portfolio size effect—get the last doubling, but don’t be thrown out at home plate.
Get the Last Doubling, But Don’t Be Thrown Out at Home Plate!
The portfolio size effect leads to a tough decision: a tradeoff.
All investment decisions are tradeoffs.
You want to get what you can from the market before you retire while not risking too much just at the end of the race. Yet because your portfolio is the largest right when you transition from accumulation to drawdown, you have the most to lose.
You want to get the last doubling of your money but beware the portfolio size effect.
The Lasts Doubling vs. the Portfolio Size Effect
Let’s start with risk just before retirement.
As all decisions are tradeoffs, you have to decide when is the right time to de-risk your retirement portfolio.
Why de-risk? It is because of the portfolio size effect.
Right when you have most at risk, you also have the most significant chance to participate in market growth (because your portfolio is the largest). This tradeoff is the last doubling vs. the portfolio size effect.
Portfolio Size Effect
Portfolio Size Effect has two periods, one before retirement and one after.
Above, in the years before retirement, there is retirement date risk. If the market crashes and you haven’t gone conservative with your portfolio, there is a risk you could suffer massive market losses and not be able to retire the day you desire to do so. This is a risk because many people don’t control the actual day they retire. Perhaps half of folks older than 50 are prematurely forced to retire. Physicians are less at risk than the general population of forced retirement, but if it were going to happen, it would happen during a recession and a market crash.
Retirement date risk is the risk that the market is down, clinics and hospitals are firing people, housing prices crash, and banks stop lending. As they say, “volatility clusters,” and so does lousy news during recessions.
If you have retirement date risk, then a market crash may force you to work longer, which you may not be able to.
After you have pulled the trigger and retired, then you have sequence of returns risk. I have blathered on enough about sequence of returns risk in previous pieces, so I’m not going to go further on the topic now.
Regardless, the period of maximal portfolio size effect is also when your last doubling is taking place. You need your last doubling!
The Last Doubling
Compound growth means that time is your friend. You expect your investments to double for you every 5-15 years.
Say, for instance, you have a 7.2% yearly return. Given the rule of 72, your money will double every ten years. If you have 1M, you will have 2M, then 4M, then 8M. That last doubling gives you four times more than your first doubling! That is the power of compound growth.
The rule of 72 describes the effect of compound growth. How does it work? Take your yearly interest rate and divide it by 72, and it tells you how many years it takes for your money to double.
Or, take the number of years and divide it by 72, and you know what IRR you need to double your money. [Note, the IRR or internal rate of return is also known as the geometric average. This is a more accurate representation of the hurdle rate than you need, rather than the arithmetic average. For example, if you gain 50% and then lose 50%, your arithmetic mean is zero (50-50/2=0), whereas your actual return is the geometric mean, a loss of 25% (100*0.5*1.5=75, which is a -25% return). Ignore this part if you want to, but you need to understand it at some point.]
The point is that you may need that last doubling to provide a quality of life worthy of your goals in retirement. But this is right at the maximal time of the portfolio size effect!
Time in the market is more important than timing the market, yet the risk is vast in “the retirement RedZone.” This, of course, is a trademarked phrase used to simulate the difficulty of scoring a touchdown in football when you are close to the endzone. But, of course, the closer you are to the endgame, the more difficult it becomes. Because then you have the most to lose!
The Portfolio Size Effect and the Last Doubling
Right before you retire, you have the most to lose!
Think about it… early on in your investing career, you only have a small amount of money at risk, and you have a considerable amount of human capital.
Above, your total wealth is measured along the top and increases slowly with time. Total wealth is the addition of financial capital and human capital. Your human capital starts very high and is most of your total wealth early on in your career.
Later, your financial capital starts to take off and eventually becomes all of your total wealth—compound growth at work.
The implications here are huge, as you can take many risks when you are young, but not a lot of risks when you have little human capital left. You no longer have time to make it up as your human capital fades.
This brings us back to the idea of the fallacy of time diversification. Most think that stocks are safer the longer that you own them. This is true if you look at the average return you get overtime. But not true if you look at the geometric return.
Think about it, if the year before you need a pile of money is the year it gets cut in half, then the actual return you get in your pocket is half of what it otherwise might have been. The risk of a market crash to your actual nest egg is enormous when you get close to needing it.
That’s why you de-risk: to mitigate portfolio size effect.
Risk of Not Meeting Your Goals vs. Risk is Highest the day Before you De-Risk
In essence, the tradeoff of the last doubling vs. the portfolio size effect is about the risk of not meeting your goals vs. that risk is highest the day before you de-risk.
This may seem obvious, but let’s discover that risk is not the same on each side of the equation.
Risk of not meeting your goals means the risk of leaving life unlived. If you can get that last doubling, you have a lot larger nest egg to participate in experiences and life in general during your retirement. Again, you might have 4x more if you participate in equity growth for a few more years.
If you are constrained in retirement, it is not the world’s end. But it is nice to have the ability to fly first class (so that your kids don’t after you pass!). Unfortunately, many folks need that last doubling, which leads to increased risk in the last few years before retirement as they reach for yield.
Because the risk to your portfolio is most significant the day before you de-risk. Yes, the risk of a market crash is always higher tomorrow than today, but if you de-risk today, that changes everything.
Summary: The Last Doubling vs. the Portfolio Size Effect
In summary, the risk is highest the day before you de-risk. The reason: portfolio size effect means that you will have to keep working (if you can) or suffer sequence of returns risk.
But the real risk is not meeting your goals in retirement.
The basic idea: Get the Last Doubling, but don’t be thrown out at home plate.
As your human capital decreases, it is time to take some chips off the table. In the tradeoff to the last doubling vs. the portfolio size effect, understand when you have won the game.
So, we started out with how to be aggressive with your drawdown asset allocation, and next, we discussed why the risk is the largest right when you might want to be most aggressive.
Well, you have oversaved for retirement. The real question you need to be asking yourself is how well do I sleep at night, not how rich are the kids going to be?
How Well Do I Sleep at Night vs. How Rich Do I Want the Kids to Be?
Investing in retirement is all about tradeoffs. Actually, all decisions are tradeoffs—when you choose one path, you can’t go down the other—but let’s focus on retirement investing!
What are the major tradeoffs you face when investing during retirement?
Remember, this blog is for those who have oversaved for retirement. This is a safe space to discuss first-world problems! If you have oversaved for retirement, you need to decide on your asset allocation: how well do I sleep at night vs. how rich do I want the kids to be?
How Well do I Sleep at Night vs. How Rich do I Want the Kids to Be?
If you have oversaved for retirement, literally, you could stuff your mattress with cash, and you’d be ok (unless there is a fire in your home).
Or, conversely, you could stay 100% invested in equities and just survive the badness that is reverse dollar-cost averaging (sequence of returns risk). Even if you are selling stocks at all-time lows, you’ll have plenty of money left over at the end of your life.
How do you decide if you could be 100/0 or 0/100 and be just fine?
I like this tradeoff: how well do you sleep at night vs. how rich do you want the kids to be?
Let’s look at two ways to slice this pie: time segmentation (bucketing) or total returns.
How Rich Do You Want the Kids to Be: Time Segmentation
And by the way, this could be for charity, grandkids, or anyone else. The point is, you don’t need all the money, so what do you do with it?
Bucketing (aka mental accounting or time segmentation) just makes sense to some people. If, say, you had a $4M nest egg but only needed $2M of it, you could consider the asset allocation of your $2M different from the kids’ $2M.
Say you wanted to be 60/40 with your portfolio and 100/0 with the kid’s portfolio. Open up two different IRAs and two different brokerage accounts (or whatever accounts you have) and label them separately. In one account, yours, go the traditional 60/40. In the other, take all the risk you want (since the kids won’t get it for 20 or more years); go 100/0.
Well, smoosh the two together, and you get 80/20 for your overall asset allocation.
- Time segmentation: I need one account soon (mine is 60/40) and one account later (kids is 100/0)
- Mental accounting: my account and the kid’s account
- Buckets: my bucket and the kid’s bucket
But, in summary, you are 80/20.
How Well Do You Sleep at Night? Total Return
Because the dirty little secret of mental accounting (it is not a secret, by the way) is that it all collapses down to one asset allocation on your one portfolio.
Say you have 20% of your money in cash for the “now” bucket, 60% of your money as 60/40 for the “soon” bucket, and the last 20% of your money 100% equities for the “later” bucket. Well, you are 60/40. You have just given the buckets different labels and titles to feel more comfortable spending the cash now while being more aggressively invested for later.
Some suggest that those who like optionality but have a “safety-first” attitude should follow the bucket approach. You like knowing where the now, soon, and later money is, giving you the optionality to spend more now. But you also don’t want to aggressively invest with the funds set to be consumed soon. So, you have the buckets.
Again, the whole portfolio collapses down to one overall asset allocation.
Instead, many of us like the total return approach. Just have your portfolio allocated to promote sound asset location principles.
Because, remember, money is fungible.
This is important. Otherwise, you get stuck thinking that you need to have, say, five years’ worth of withdrawals in your brokerage account because you will be spending from it soon. But since you are not supposed to have bonds and cash in your brokerage account due to tax drag.
What to do? Remember money is fungible.
So, say you just have stocks in your brokerage account, but you need the money, and the market is down. Just sell your stocks in your brokerage account, then sell bonds to buy those same stocks in your IRA. This is (-) stocks (-) bonds (+) stocks. In the total return approach, you have sold bonds to pay for your expenses out of your brokerage account (which doesn’t have any bonds because you want to be tax-efficient!).
Summary: How Well Do I Want to Sleep At Night vs. How Rich Do I Want the Kids to Be
If you have oversaved, you have the luxury to have whatever asset allocation makes you sleep well at night. If you sleep well on a pile of cash, have at it!
Conversely, we know over time that stocks will outperform cash, bonds, and just about everything else (aside from leveraged real estate and the occasional small business).
How well do you sleep at night vs. how right do you want the kids to be?
If you want to take risk (and you know that you don’t need the money anyway), you (or, more aptly, the kids since it is really their money) can take as much risk as you want.
You might think you don’t want to give the money away right now because you might need it in 20 years for, say, absurd and improbable long-term care expenses. Of course, it is better to spend your money on things that you and the kids enjoy; to share experiences with them while you are still alive.
But if you are going to leave the money to the kids (or to charity) when you pass, you can (and perhaps should) take more risk with it. Consider a pre-retirement glidepath that is personalized to your needs, and remember, you don’t need to rebalance in retirement.
You can do that by mental accounting or by total return. But you, you over saver you, can be 100/0 or 90/10 or whatever you want because you know you have plenty of safer money. You have won the game. So play with the money you don’t need.
So let’s start dialing in our asset allocation during the drawdown phase. What about a target date fund?
Are Target Date Funds Good In Drawdown?
Let’s discuss seven reasons not to use target-date funds during the drawdown phase of retirement.
A fund-of-funds (like a target-date fund) is simple, efficient, and easy during accumulation. Remember, though, during de-accumulation, everything changes.
You should dollar-cost-average into target-date funds and take advantage of the glidepath that gradually dials down market risk. Risk, however, is different in retirement! Sequence of returns risk is much more critical than market risk when retired.
Let’s go over the seven reasons you want to forget target-date funds in retirement.
What are Target Date Funds?
First off, a target-date fund is a fund of funds. They generally include US stocks, international stocks, and bonds. Many different target-date funds can be active or passive and may contain cash, TIPs, and other slices (emerging, REIT, commodities, etc.).
They are most commonly used in defined contribution (401k, 403b) plans; participants are defaulted into target-date funds by their employer. They typically are labeled at 5-year retirement intervals (2020, 2025, 2030, etc.), which indicate the year you are likely to retire. Gradually, they dial back the percentage of stocks in favor of bonds and other safer assets.
Thus, your “risk” (at least as measured by market risk or volatility) decreases as you get older. How the asset allocation changes over time is the glidepath.
In essence, target-date funds balance growth vs. risk and de-risk over time.
Target Date Funds are for Accumulation, not Drawdown
Target-date funds are specifically designed for accumulation, not for drawdown.
Target-date funds leave much to be desired when you are withdrawing from your accounts to provide retirement income.
After their expiration (for example, the 2020 fund now in 2022), most target-date funds become income funds. Interestingly enough, income funds are static and very conservative, with only 20-30% in stocks. Therefore, these income funds are not ideal for creating sustainable, stable, and inflation-adjusted income for the duration of retirement.
So, in reality, it is not the target date fund you should avoid in retirement; it is what the target date fund becomes!
Let’s cover the seven reasons you should not use a target-date fund in retirement.
Target Date Funds can be “To” or “Through”
Does your target-date fund go “To” or “Through” your target date?
Both are available, but “through” is the most common. With a “through” fund, the asset allocation gets more conservative even past your retirement date.
Let’s look at some examples:
- Vanguard: Glidepath goes from 40% stocks to 30% stocks the seven years following retirement, then becomes the income fund
- Fidelity: Fidelity continues to get more conservative for 20 years following retirement and winds up with 24% stocks when it becomes the income fund
- T.Rowe: Amazingly, T.Rowe takes 30 years to glide down to 20% stocks!
Compare these “through” plans to a “to” plan that hits the income fund the same year you retire. These types of funds generally become the income fund that very same year.
Above, you can see the difference between a “to” and a “through” plan. On the top, a to plan hits a static asset allocation the year you retire (red up-arrow) and never changes after that. Below, a through plan continues to get more conservative even after the target date.
This enormous variability in target-date funds is reason #1 why you should not use one in de-accumulation. What does your target-date fund even do, and is that right for you?
Active vs. Passive Target Date Funds
There are plenty of very expensive, actively managed target-date funds out there on the marketplace. In addition, some custodians offer both active and passive versions of their target-date fund.
Folks, it is 2022. We know active management, especially after expenses, does not perform better than broadly diversified, inexpensive index funds. The same holds with target-date funds.
Avoid actively managed target-date funds if you can! Especially in retirement.
Target date funds are just too conservative for many, especially in retirement. Whatever happened to the standard 60/40 portfolio? While it is good to de-risk before retirement, the 20-30% stocks are not enough to outpace inflation over time and provide a stable income for retirement.
Are target-date funds too conservative to be used in retirement? Yes!
Above, you can see the maximum, minimum, and industry average glidepath. Some funds are 20% equities, and some are 60% at the target date. The average is a 40/60 portfolio. It is interesting to see the different shapes of the glidepaths above. Which one is right for you? In retirement, target-date funds are not right for you!
Target Date Funds are too conservative to be used during de-accumulation.
Target Date Funds Don’t Actually Provide Income
Target date funds are not annuities. For those looking for stable income, an income fund is not ideal.
I believe in good annuities which can provide stable income for those who are not comfortable with stock market risk. Instead of being 70% plus invested in bonds, most retirees would benefit from annuitizing those bonds with SPIAs. I plan on replacing some of my bonds with annuities in retirement, do you?
So, for some, target-date funds are too aggressive! These folks would be much more comfortable with guaranteed incomes rather than an income fund.
Target Date Funds are NOT for your Brokerage Account
To be clear, target-date funds may be ok for accumulation in your employer plans (which are pre-tax), but they should not be used in Roth accounts or brokerage (after-tax) accounts.
In Roth accounts, you have way too many other better options for both accumulation and de-accumulation.
For brokerage accounts, please do not use target-date funds! Here, you might wind up with a low basis position, which means you have to pay capital gains when you sell the funds. And you do not want target-date funds causing an increasing amount of ordinary income every year, yet you cannot sell it due to the embedded capital gains! Bonds (and thus target-date funds) should be in your pre-tax accounts rather than your brokerage account due to tax consideration (also known as asset location).
Target date funds average about 0.5%. Since cost is the most correlated variable with future returns, you want to pay less to make more.
When you are working, you often are stuck in your 401k. Use the best funds you can that meet your goals. But in retirement, you have many better options (usually after rolling over to an IRA). Cost is a huge reason why target-date funds are not indicated in retirement.
Target-Date Fund Problems during Withdrawal Phase
During your withdrawal phase (retirement), you sell investments to create income. Ideally, you would like to sell your best-performing asset and not sell stocks when they are down.
Since target-date funds rebalance daily, you are always de-risking when the market trends up and de-risking overtime via the glidepath.
When you sell investments to create income, however, you have to sell both the stocks and the bonds when you sell shares of your target-date fund. If the market is down when you take a withdrawal, you are selling stocks when they are low, thus locking in the losses.
Some consider this a benefit of target-date funds, as they automatically rebalance for you. Outside of a target date fund, if stocks are down and you sell bonds to create income, you still rebalance your account back to your desired asset allocation. So either way, you wind up selling stocks to get your risk level (asset allocation) back into shape.
But let’s take a painfully deep dive into why that is not true. Here is the special bonus reason you should not have target-date funds in retirement.
Bonus: Number 1 Reason to not have Target Date Funds in Retirement
This is a bit complicated but stick with me because this is the top reason not to have target-date funds in retirement.
This idea starts with rebalancing. How often should you rebalance your accounts, and does that change in de-accumulation?
There is debate about how often you should rebalance during accumulation, but I suggest likely every 1-2 years is frequent enough. This allows you to participate in a momentum tilt without getting too far outside your desired asset allocation (and thus the amount of risk you are willing to take during accumulation). Remember, you don’t rebalance during accumulation because it gets you more return. You rebalance because it reduces volatility (market risk).
Next, how often should you rebalance in de-accumulation?
Risk is different in de-accumulation. The risk is not one of market risk; it is sequence of returns risk. The idea here is that a bad sequence (over a few years) while you are withdrawing from your accounts can unleash a portfolio death spiral if you sell your assets when they are low, thus locking in the losses.
In fact, rebalancing in de-accumulation has less to do with mitigating market risk, and more to do with mitigating sequence risk.
Please stick with me for a second. If you sell your target-date fund (which rebalances daily) during a market correction, you will be fine as long as the market goes up after that. But during a bad sequence, the automatic (daily) rebalancing of the target date fund leads you to sell stocks when they are down continually. Year after year or month after month, you sell stocks when they are down.
On the other hand, outside of a target-date fund, you might sell only bonds when the market is down. You don’t need to rebalance, and you can see what happens the following year in the market. If it is still down, you can continue to sell “safer assets” during subsequent down years and not get trapped by sequence of returns risk. Here, you never sell stocks when they are down, and you don’t rebalance into the teeth of a poor sequence.
Remember, de-accumulation is the opposite of accumulation. With target-date funds during retirement, you may not mitigate adequately against a poor sequence of returns. Instead, you double down on the poor sequence due to the automatic rebalancing. Outside of a target-date fund, you can wait out the downturn.
Some would accuse me of market timing since I am not rebalancing during a poor sequence. But how often should one rebalance during de-accumulation? Are you sure you are supposed to rebalance at all? Really? Show me the evidence that supports rebalancing during retirement. There are plenty of opinions out there, but what is the evidence?
Sequence of returns risk is the top reason why you should not use target-date funds during retirement.
Summary—7 Reasons You Should Not Use a Target Date Fund in Retirement
In summary, don’t use target-date funds in retirement.
During accumulation, they may be appropriate for your pre-tax accounts (but not your Roth or brokerage accounts) if you have no better alternatives. Indeed, they may be the best choice in your 401k before separation.
But during the withdrawal phase—de-accumulation or retirement—target-date funds are not indicated. You are better off (7 ways plus a bonus) separating your stocks and bonds and selling the winners. Don’t sell the losers and lock in paper losses, especially during retirement.
So, what should your asset allocation be in drawdown? Should you rebalance?
Should You Rebalance Your Portfolio in Drawdown?
When you are retired, should you rebalance your portfolio?
Of course, it depends on your goals, timeframe, and the purpose of the money.
But what evidence is there that supports portfolio rebalancing when retired? I will argue that very little evidence supports rebalancing your portfolio in retirement. Specifically in the drawdown, or withdrawal, or distribution phase of retirement.
So, should you even bother rebalancing your retirement portfolio? Maybe not!
Why Rebalance your Portfolio (in Accumulation)?
Let’s start way before retirement… in accumulation.
In your accumulation phase, rebalancing is essential as it gets you back to your desired asset allocation. As stocks have higher expected returns than bonds, your portfolio becomes riskier (as measured by volatility). You rebalance your portfolio in accumulation to control risk.
Rebalancing lowers your expected return over the decades. As a result, your risk-adjusted return is higher, but your actual return is usually lower.
This is important, and many people get it wrong, so let’s restate the point: rebalancing during accumulation means leaving money on the table, on average. Theoretically, beyond controlling risk, there is the idea that rebalancing allows you to buy low and sell high as assets revert to the mean. (This may be true between high expect return assets such as stocks, but not when you rebalance between stocks and bonds).
But as we know, over the decades (and if you can tolerate it), being 100% equities all the time increases returns along the efficient market return curve. Rebalancing, conversely, increases return per unit of risk but not overall return. So risk-adjusted returns are higher if you rebalance your portfolio every 1-2 years or via tolerance bands.
Thus, rebalancing is recommended for most to keep your asset allocation and risk-adjusted expected return in check.
What about rebalancing your retirement portfolio? Should you rebalance your portfolio in de-accumulation (retirement)?
Should You Rebalance Your Retirement Portfolio?
Remember, in de-accumulation (also called the withdrawal phase of retirement, or simply just “retirement”), your risks are different than in accumulation.
By this time, I hope you understand that market volatility is not an unknown risk. It is a known risk and a feature rather than a bug of the stock market. The market will dip and crash, and it will feel like you are dying after three years of horrible returns; but, over time, if the US economy grows, so does the stock market. I will say this: volatility is not a risk for retirees because they have planned for it. That is what retirement planning is!
You plan for it by going conservative and de-risking before retirement. Because the actual risk in retirement is not volatility, it is sequence of returns risk.
Sequence of returns risk is a much more considerable risk, as is longevity, inflation, and long-term care risk.
So if rebalancing helps mitigate market risk in accumulation, and there is no market risk in de-accumulation, should you rebalance your portfolio in retirement?
Let’s see what effect retirement portfolio rebalancing plays regarding the significant risks in retirement.
Does Rebalancing Your Portfolio Mitigate Major Retirement Risks?
Does rebalancing your portfolio in retirement mitigate any significant retirement risk? Nope.
Rebalancing your retirement portfolio increases the risk that you will run out of money and suffer from longevity risk! More on this later when we review the academic data on the topic.
Inflation risk is also worse with longevity if you rebalance your retirement portfolio. It would be best to have a high proportion of equities to outpace expected inflation. (Remember, expected inflation is already priced into TIPs, and you only get a bump if there is unexpected inflation.) See below.
Long-Term Care Risk
This is more complicated and likely not all that related to portfolio rebalancing, so let’s skip this risk.
Sequence of Returns Risk
Sequence of returns risk is why you should not rebalance your retirement portfolio. See the bonus section of my blog on why you should not use target-date funds for the TL;DR.
Portfolio Size Effect
We discussed this above.
All good and well!
But what happens to sequence of returns risk once the sequence has already occurred?
What Happens to Sequence of Returns Risk AFTER the Sequence is Over?
Think about this for a second: if the largest risk a retiree faces is sequence of returns risk, what happens to that risk during and after that poor sequence of stock market returns?
Unless it is a double-dipper dead-cat-bouncer don’t-catch-the-falling-knifer, the risk is over! Think about it: if the risk is a bad sequence, then after the bad sequence the risk is much less that you will have a bad sequence!
What are the options for portfolio rebalancing after sequence of returns risk is over?
What Should You Do AFTER Sequence of Returns Risk?
After sequence of returns risk is over, there are three different ways to think about asset allocation and retirement portfolio rebalancing: static, time-based, and event-based.
Static Retirement Portfolio Rebalancing
This is the traditional model of retirement portfolio rebalancing: you should rebalance and stay static at very conservative levels. Most target-date funds remain static at 20-30% equities throughout retirement regardless of income needs or sequence statues. This is why target-date funds are not suitable during retirement.
Time-Based Retirement Portfolio Rebalancing
Time-based retirement portfolio rebalancing techniques include the rising equity glidepath and a bond tent.
Rising Equity Glidepath
With a Rising Equity Glidepath, de-risk until the point of retirement, and then you slowly increase your asset allocation over time back to a higher risk portfolio. This ends up looking a bit like a seagull.
Above, you can see a rising equity glidepath. Over time de-risk, then come retirement, you increase your risk again slowly over time. Note that you likely don’t get as risky in the later years as you are early in your accumulation.
A bond tent is similar to the above but structurally different. With a bond tent, you rapidly increase and decrease your bond allocation during the time of portfolio size effect risk, which (instead of a seagull) looks like an inverted-V or a tent. Bond (or safe income or more likely “safer income”) allocation slowly increases, then rapidly increases and decreases.
Event-Based Retirement Portfolio Rebalancing
I’m going to coin a phrase: Event-Based Retirement Portfolio Rebalancing.
This is not the band-rebalancing when you rebalance when, for example, your asset allocation is 5% above or below where it is supposed to be (which is a decent way to rebalance in accumulation).
With event-based retirement portfolio rebalancing, you rebalance into the teeth of sequence of returns risk. After all, after the bad sequence of returns, the risk in sequence risk abates. If you plan on increasing your asset allocation after return risk is gone, why not do it as the market goes down?
- Remember, once the “sequence” happens, then risk is gone!
- “Rebalance” into the sequence (70/30 up to 90/10)
- Down 10% 75/25
- Down 20% 80/20
- Down 30% 85/15
- Down 40% 90/10
Sequence of Returns Risk goes away after the bad Sequence!
Above, you can see that we are 70/30 and de-risked for retirement. But, then, the bad sequence happens. If the market goes down 10%, you increase your asset allocation. And you continue to increase to your post-sequence goal the worse the sequence is.
Well, indeed, this is catching the falling knife and market timing. But it is a programmatic way to address post-sequence risk and something to consider.
Downsides to Event-based and Time-based Retirement Portfolio Rebalancing
Of course, even beyond the smack of market timing, the most significant issue with event-based and time-based retirement portfolio rebalancing is one of investor behavior.
It all comes down to investor behavior. How difficult behaviorally is it for an “elderly” retiree to increase their asset allocation? It is pretty hard. In fact, it is usually not recommended, which is why we have the static rebalancing in target-date funds.
But there is a difference between what is difficult and what is efficient. And you are not the average stock investor who is scared of market volatility.
As for the bottom line… what would I recommend? Don’t rebalance your retirement portfolio!
Don’t Rebalance Your Retirement Portfolio.
At last, we have arrived! Don’t rebalance your retirement portfolio.
After all, what evidence is there that rebalancing your portfolio in retirement is useful? None! In fact, what data there are support not rebalancing retirement portfolios. Let’s review.
Study 1: Is Rebalancing a Portfolio in Retirement Necessary?
While the wisdom of rebalancing in the accumulation phase of the life cycle is widely accepted, the wisdom does not appear to extend to the withdrawal phase. In both the bootstrap analysis and the temporal order analysis, 1. Rebalancing during the withdrawal phase provides no significant protection on portfolio longevity. This conclusion appears to hold for withdrawal periods of 15, 20, 25, and 30 years. The temporal order analysis suggests Rebalance increases shortfalls and, in fact, is harmful. 2. The larger the proportion of stocks to bonds in the portfolio, the longer the portfolio tends to last. This conclusion is in agreement with previous research on the topic. (Emphasis mine)
This is an interesting paper and, I suggest, required reading.
The conclusion: if you start with a 4% rule for withdrawals, the failure rate is low regardless of what you do with your retirement asset allocation. Further, it is best to spend down your bonds first and leave your stocks (with their higher future expected returns) for later spending.
Is it risky to spend bonds first and leave yourself all stocks in the end? It depends on what you mean by risk! Is risk volatility, or is it running out of money? If you are worried about volatility, rebalance. If you don’t want to run out of money, sell your bonds first and let your asset allocation get more aggressive with time.
In essence, this is like a rising equity glidepath. You just spend your bonds until you run out, then you spend what is left. Interesting. Next:
Study 2: Determinants of Retirement Portfolio Stability and Their Relative Impacts
Although declining interest rates have been shown to dramatically reduce portfolio sustainability, the impact of this condition may be ameliorated to a degree by moving away from the widely adopted constant allocation with annual rebalancing withdrawal strategy, and perhaps even more so by abandoning stocks-first withdrawals in retirement.
Fascinating! Again, more evidence that selling bonds first (rather than rebalancing in retirement) provides more portfolio sustainability now in the face of increased inflation.
In summary, there is no evidence that rebalancing is important in a retirement portfolio. Further, what data there is supports increasing your asset allocation if you can do so.
One Final Point About Mental Accounting
Finally, I’d like to tell you why having a lot of equities late in retirement is ok.
If you have survived past mid-retirement with a decent-sized portfolio, most of the money left in your nest egg is not yours. Whether you plan to leave the money to your heirs or to charity, they may have different goals, purposes, and time frames for the money than you do.
This is a form of bucketing (mental accounting) for the post-sequence risk portfolio. Some say that 80/20 is pretty risky for an 80-year-old. What if you were only going to spend half of it and leave half behind for your kids? Your half can be 60/40 and their half 100/0, which means that the two buckets together are 80/20. You might even set up separate brokerage accounts or IRAs with different money intended for different goals.
Or, you can have your Roth 100% stocks for the kids and have other accounts less risky.
What is the purpose of that money?
Summary: Is portfolio rebalancing during retirement necessary?
In summary, is portfolio rebalancing during retirement necessary? Nope. Should you do it? Maybe!
Asset allocation is a primary decision. After deciding to invest, knowing what your asset allocation should be is the most critical decision.
Remember, you set your asset allocation respectful of the bad times. In accumulation, rebalance during the good years to manage risk. In de-accumulation, perhaps you might consider rebalancing during the bad years to keep sequence of returns risk in check.
Rebalancing in accumulation costs you money, but it lowers your risk. In retirement, rebalancing your portfolio also costs you money but maybe the right thing to do behaviorally.
This is just another strategic decision to be made in retirement. In retirement, do you want just to sell your winners? Just sell your bonds? Keep a static asset allocation? Drift up over time? Or, maybe, jump up into the teeth of a poor sequence.
Take sequence risk into account, but consider how to rebalance your retirement portfolio if you want to deal a blow to longevity and inflation risk.