De-Risking your Portfolio Prior to Retirement: The Pre-Retirement Glidepath
De-Risking your portfolio for retirement and a pre-retirement glidepath are important yet neglected topics of conversation.
Assume you want to retire at some point. Currently, in the depths of accumulation, you stash away money as per your investor policy statement in an asset allocation that allows you to sleep at night, yet meets future income goals.
When do you de-risk this portfolio prior to retirement? Or do you continue aggressive investing to and through retirement?
What does an ideal pre-retirement glidepath look like to get your portfolio retirement ready for retirement?
How do Target Date Funds De-Risk a Portfolio for Retirement?
Target date funds actually start de-risking about 25 years before 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.
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?
Asset Allocation Before and After Retirement
Let’s look at this question visually.
Figure 2 (Bond Tents and pre-retirement glidepaths)
Let’s look at a visual of how your bond allocation might change prior to retirement. Above, bond increase from age 25-55 from about 10% up to 40%.
Next, rapidly increase bond allocation from 40% up to 70% over the 10 years before retirement.
This is an interesting pre-retirement glidepath. Is this the ideal way to de-risk the portfolio for retirement? What is the slope, the rate, and what age is the landing point?
Key Point: When and How Much Should You De-Risk before Retirement
This point is key. When and how much should you de-risk prior to retirement?
Let’s look at them individually.
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.
When should you increase bond allocation- that is- when should you de-risk prior to 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 to your long term net worth if you are withdrawing from a down portfolio.
The withdrawing part is key. This is why you have bonds in your portfolio: in case you need to withdrawal money during a sequence of bad returns. When is sequence risk at its very worst?
Sequence of Return Risk and De-Risking for Retirement
In Figure 3, you retire at year 30. Prior to 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 return risk?
Twenty-five years before retirement (which is year 5 of the graph), you see there is very little explanatory power of a negative market causing sequence risk. This slowly but steadily increases over time until the year you retire.
Year 30, (the year you retire in the graph above), the explanatory power jumps up by 3.3 times! Yes, sequence of return risk is largest the year you retire and start withdrawing from your account.
Here, we are not focusing on the “tail” risk once you retire, rather the risk BEFORE you retire. Looking at Figure 3, the risk in the decade 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 difficult to study pre-retirement sequence of return risk.
Looking at Rising Equity Glidepaths, we can use historical data or Monte Carlo simulation to study what we should do in the FUTURE after retirement.
But before retirement, looking to the left side of the graph above rather than the tail, it is more difficult to use future possibilities to predict what the ideal slope of the bond tent should be.
Stick with me here for a second.
If I’m trying to study WHEN you should de-risk your portfolio prior to retirement, the only data point of significance is WHEN the market drop happens. Obviously, the best time to de-risk your portfolio is right before a big 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 return 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.
I just made Figure 4 up to represent a thought process. There is no data to support it.
But if we adequately mitigate Sequence of Return Risk, which I suggest is the largest risk pre-retirees face today, you will have de-risked by 5 years before retirement.
With that in mind, what I’m trying to demonstrate above: the mitigated portfolio is at equal risk in years -10 through -5 (5 to 10 years before retirement) as it is the year of retirement—when the unmitigated portfolio faces massive sequence risk.
In Figure 4, “risk” on the left scale is relative and not any demonstrable value. As you live pre-retirement in real time (again, rather than looking at the future risk after retirement), you can only choose to de-risk now or at some future time.
Thus, risk is highest the year before you de-risk your portfolio, and increases real time every year you don’t de-risk.
How to De-Risk a Pre-Retirement Portfolio
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, overtime, 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 (or never do them in the first place in your taxable accounts!) 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, during your transition phase, buy fixed income assets rather than stocks.
There are many ways to skin this cat, and substance beats form when de-risking the portfolio before retirement.
A harder 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, in accumulation mode, you should take as much risk as balances cans and needs. 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 is anywhere from 60/40 to 100/0 stocks to bonds.
How much should you de-risk?
Look back at at Figure 1. Vanguard has a 40/60 asset allocation 10 years before retirement. This then decreases to 30/70 at retirement. Further, they get even more risk averse through retirement and decrease to 20/80 over the next 7 years. Their glidepath stays at 20/80 from then on.
Similarly, back in Figure 2, there is a 30/70 asset allocation at retirement as well. Here, a decade before we are at 60/40. So, Figure 2 suggests a more aggressive baseline portfolio with a much more rapid change than in the target date fund.
So, should you consider starting retirement somewhere between 20/80 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.
What does an Ideal Pre-Retirement Glidepath Look Like to get your Portfolio Retirement Ready?
De-risking in preparation for retirement is important.
De-risking includes preparing for sequence of return risk. I suggest you consider de-risking your portfolio 5-10 years prior to 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 really 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 do decide to do it.