Asking a financial planner what the best asset allocation is for retirees is a bit like asking a dietitian what the best diet is for retirees. Ask five professionals and you’re likely to get five different answers, rooted in personal biases and beliefs. So, what’s the real answer? It’s personal and it’s complicated. I’ve got clients who look almost the same on paper but don’t have the same stock-bond breakdown.
Below are five factors that can lead you to something appropriate for your situation.
1. What’s your risk tolerance?
If you’re retired, or close to it, odds are you’ve taken a risk-tolerance assessment at some point in your investing journey. Tools like Schwab Intelligent Portfolios will spit out a model portfolio based on your answers to their questions. While the philosophies and approaches vary, all these questionnaires are trying to determine one thing: How much will you panic when the market drops?
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As a fellow human, the unfortunate reality is that we are almost perfectly designed to make bad investment decisions in volatile markets. Our inclination to buy high and sell low is well documented in Vanguard’s Advisor’s Alpha study. Knowing and investing in accordance with your risk tolerance is your first line of defense against those emotional decisions.
Essentially, these tools will give you a risk score, asset allocation or max loss you’d be comfortable with, based on your answers. In my experience, those who are invested way beyond that comfort level are the first to call when things go south.
Risk tolerance shifts over time, and I have seen it shift dramatically once the paychecks stop. Therefore, your portfolio that shifts to more stock over time if you don’t rebalance will likely move further and further from your comfort level.
If you want to see where you stand today, you can use a free version of the same tool we use.
2. What’s your risk capacity?
Risk capacity and risk tolerance are sometimes used interchangeably, but they are not the same. Risk tolerance is based on emotion. Risk capacity is math. It measures how much you can afford to lose. This is a much more common calculation in the institutional money management space.
Take the example of a pension fund. Managers must calculate how much they can afford to lose and still pay plan beneficiaries.
There are situations where risk-takers can find themselves in hot water because, while they are comfortable watching the market get cut in half, their financial plan actually doesn’t mathematically work in that scenario. Retirement is not like your accumulation years, when you can shut your eyes and ignore the pain.
If you are drawing from your portfolio, you should use your financial plan to see how much you can afford to lose before things get dicey.
3. What’s your time horizon?
I never want to be in the business of telling someone that they can’t take their family vacation to Italy because the market is down. The pizza and wine are just too good.
In all seriousness, I do not believe that money for one-time expenses within two years — vacations, car purchases, home improvements, etc. — should be invested in a vehicle with market exposure. The two-year component of that has to do with how long it typically takes to recover from a bear market.
While I do not fully subscribe to “the bucket approach,” I will often allocate based on time horizon; e.g., vacation funds for the next two years will be in cash or a cash equivalent. Money needed in the next two to 10 years will be allocated in alignment with your financial plan, risk capacity and risk tolerance. Money needed 10-plus years out will be invested more aggressively.
For this reason, your Roth IRA and your brokerage account probably shouldn’t have the same asset allocation.
4. What kind of returns do you need?
Like risk capacity, this is just a math problem. You will also find this answer in your financial plan. Everyone would like to spend what they want without having to worry about running out of money, while taking no risk. Very few people can afford to do this.
Your financial plan will have an asset allocation with an assumed rate of return. If you make your portfolio more and more conservative, that assumed return will go down, and at some point, the math will no longer work. If you want to build out your financial plan to see what you need, you can use the free version of our software.
5. What are your legacy goals?
If you are hoping to leave a significant sum to a cause or to your family, you should change your investment allocation. You have now stretched out your time horizon beyond your life expectancy.
The SECURE Act made Roth IRAs even more advantageous as a legacy tool. As a result, we are usually allocating for the next generation within a Roth IRA. While my clients’ overall asset allocations will fall in line with the above factors, it is common to have their Roth accounts be all stock. These are usually the last place we go for money, and they don’t have the annual required minimum distributions (RMDs) that their pre-tax cousins do.
It's important to remember that your asset allocation is simply a tool to help you do the things you want to do in retirement. Allocating too aggressively is like driving 25 mph over the speed limit. You may get to your destination a bit earlier if you’re lucky. You may crash and not get there at all. Allocating too conservatively is like going 10 mph below the speed limit. You may not get to your destination with enough time to actually do something you love.
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