Our clients often ask if they should adopt a more conservative asset allocation between stocks and bonds as they age through retirement. It is reasonable question that lacks a simple answer. To some degree the recent popularity of target date funds in 401(k) accounts have created a bias toward a belief that you should always reduce your equity exposure as you age. The incremental changes in allocation between equities and fixed income is called the “glide path” associated with various target date funds. While most glide paths suggest decreasing equity exposure as you age, recent studies have suggested the best strategy might be to increase your allocation to equities as you age.

First, let’s discuss the various factors to consider when determining an appropriate starting asset allocation mix. A primary factor in determining asset allocation is the amount of monthly expenditures you expect to incur in retirement years. The prevailing wisdom among most people is that they will adjust their spending, based on the performance of their retirement portfolio (i.e. if the market performs poorly, they will cut back their spending; if the market does well, they will enjoy a nice vacation). The TFA philosophy is to put clients in a position where they don’t have to worry about market swings in retirement. This is what we mean by “living with intention.” We want you to visualize how you want to live your retirement. We work with you to help determine your goals, and then we help illustrate how your asset allocation will give you a “confidence level” that you will be able to live out your goals.

We mentioned that your spending goals are one factor that helps arrive at an appropriate asset allocation. There are many other factors. How much will you receive in social security (we help you determine the optimal social security claiming strategy)? Will you be receiving any other guaranteed retirement income through a pension plan or annuity? Most importantly, what are your goals in retirement and what type of legacy would you like to leave behind?

In the mid 1990’s and early 2000’s most good financial planning practitioners started emphasizing a retiree’s average portfolio returns are not as important a factor in determining the success of your financial plan, but rather the sequence of those returns. After all, it doesn’t matter if your portfolio returns average 6% over 25-30 years of retirement, if the portfolio returns were negative for the first 10 years of retirement when you needed to withdraw money to meet living expenses. Financial planning software that utilizes Monte Carlo analysis can stress test your portfolio in early years to determine a confidence level for meeting your retirement goals.

Based on the results of these stress tests we can determine an appropriate asset allocation at the outset of your retirement years. In general, we like our clients to have 8-10 years’ worth of expenses protected against a dramatic decrease in the equity market. The #1 culprit for derailing someone’s retirement plan is a sudden downturn in the market at the outset of retirement. We all know how the math works – a 50% decline in your retirement portfolio will require a 100% increase in portfolio returns to get back to the level where you started.

This blog post outlined the main factors we consider for a starting retirement portfolio asset allocation.  A future blog will highlight some recent research that illustrates why increasing exposure to equities as you age might be more prudent than decreasing your equity exposure. Until then, start imagining how you wish to live your retirement. Visualize your goals. We would love the opportunity to help you achieve those goals.