How much is too much risk in retirement (part 2)?

In part 1 of my post regarding asset allocation, we determined that planned monthly expenditures, social security and other retirement income sources, and desired legacy goals were all important factors in arriving at the optimal asset allocation mix for your retirement portfolio. On top of these factors, it is also important to determine the risk tolerance of the retiree. The goal is for clients to enjoy their retirement.

Risk tolerance is the amount of risk that an investor is comfortable taking or the degree of uncertainty that an investor is able to handle. In other words, risk tolerance is about emotions. Risk capacity, unlike tolerance, is the amount of risk that the investor “must” take in order to reach financial goals. Your risk capacity is determined by comparing the annual amount of withdrawals you need to take from your portfolio in retirement to the total value of your investments. The larger the withdrawal needs, the less capacity for risk. During your working years, your risk capacity is larger because you have a reliable source of income outside your retirement portfolio. Once you stop taking a salary, your risk capacity decreases. However, the reduction in outside income can be mitigated by the growth of your portfolio.

In my last post, I mentioned the sequence of investment returns can have a much larger impact on your risk capacity than the long-term average portfolio return. In other words, the inevitable ups and downs of portfolio returns must be made tolerable for investors to ensure they don’t flee the markets in sharp downturns – a step that would lower their chances of reaching their long-term financial objectives.

One popular way to manage the concerns of “sequence risk” is through a mental “bucket strategy” that breaks your investment portfolio into “buckets” that correspond to time horizon. For instance, a pool of cash might cover spending needs (not covered by social security or other income sources) for the next two years. For instance, if you determine you will need $50,000 per year, outside of social security, you might segregate $100,000 in money market funds, or cash equivalents to handle the 1-2 year “bucket.” Another “bucket” of bond investments might be earmarked for years 3-8. The bond investments should have higher returns than cash equivalents, and they should not lose much value if the stock market experiences a protracted loss in value.

By segmenting these “buckets” of cash and fixed income as insurance against an immediate market downturn, clients should get comfortable with the fact they will not need to sell equities at an inopportune time.  By employing a strategy that disproportionately spends from fixed income assets, and lets equity assets grow, will result in a rising equity allocation over time.

Traditional portfolio management would “rebalance” back to your target asset allocation, by selling equities, once your equity allocation increased beyond a pre-determined upper band. New research conducted by Wade Pfau and Michael Kitces suggests increasing equity exposure throughout retirement can actually enhance retirement outcomes.

In a world where conventional wisdom is that retirees should reduce their equity exposure throughout retirement as their time horizon shortens, this research suggests the ideal strategy may actually be the exact opposite.

The fact is market returns in the first 15 years of your retirement will have the greatest impact on whether or not you meet your plan goals. If the first half of retirement is accompanied by a strong stock market, the retiree is so far ahead that a subsequent bear market cannot threaten their retirement goal. Conversely if the first half of retirement occurs during a bear market in stocks, there is a danger that even if returns average out favorably through retirement, the portfolio might be depleted too severely by withdrawals and bad returns in the early years. In this scenario you might not have enough money left when the good returns finally kick in. In this context, the problem with the “traditional” approach of decreasing equity exposure through retirement becomes clear.

The best-case scenario is the early years of your retirement are greeted with a rising bull market. However, if that is not the case, a rising equity glidepath may be a more effective portfolio solution for sustaining a client’s retirement income. The key to implementing any strategy is open communication and trust between the client and their advisor.