I’m not going to lie. This one actually caught me a bit off guard. But it makes some sense. So bear with me before you throw out the idea completely. What idea? The idea that you should actually increase your stock allocation and exposure in retirement!
Of course, there is a little nuance. But it runs counter to one of the more basic rules of thumb in personal finance.
Let’s explore.
The traditional model for retirement stock allocation
One of my favorite rules of thumbs in personal finance is that your bond allocation in your portfolio should roughly equal to your age rounded down to the nearest ten.
For example, I am 37 as I write this. So, my ideal bond allocation would be 30%. I could then titrate this up or down based on my own personal risk tolerance. My bond allocation is actually lower than this due to my slightly above average risk tolerance.
Then, once we have bond allocation number set, it becomes really easy to figure out the rest of your portfolio, which will largely consist of stocks for most investors.
Why is this the case?
It’s pretty straightforward.
Stocks are riskier investments, with a greater potential return but also greater potential for loss.
Bonds, by their nature serving as IOUs, are more stable investments. Their upside is limited but so is their downside.
So, when you are earlier on in your investment career, you are chasing growth and can tolerate more fluctuation in exchange for (hopefully but never guaranteed) higher long term returns.
But, when you a nearing retirement, you want portfolio stability rather than growth per se. That has bonds written all over it. Thus, as your approach and then finally reach retirement, your bond allocations goes up and your bond allocation goes down.
Or so we have been told…
The monster in the closet
The biggest risk as you reach retirement is a sequence of returns risk. Basically, this mean that if the stock market plummets early in your retirement you are in trouble. Even if it picks up later in your retirement.
The reason?
Because, when you are in retirement, you are drawing down on your investment portfolio to cover your living expenses. If the market crashes early in your retirement, you still need to draw down for your expenses. So, as a result, you sell stocks when they are at a low. That spells trouble.
The way to reduce this sequence of returns risk is twofold:
- Stick to a low withdrawal rate of 4% and/or
- Keep your stock allocation to a necessary minimum (and have a greater bond allocation)
A new model for stock allocation in retirement
Fortunately for most of us, just be sheer odds, we won’t retire in horrible market conditions. By definition, most of us will retire in average market conditions.
But there is no way to predict ahead of time the exact conditions we will retire in. So we can’t say for sure we won’t be the unlucky few to retire and the exactly wrong time.
Thankfully, however, there is another option other than just staying conservative the whole way through our retirement.
Shift your gears
As you are right on the verge of retirement, rebalance your portfolio away from stocks to overweight in bonds.
This will slightly decrease your immediate returns. But it also offers protection as you test the waters to ensure that you don’t retire in a market crash and succumb badly to sequence of returns risk.
Then, once you successfully navigate the first few years of retirement and ensure market conditions are okay and your portfolio is in good shape, you can actually increase your stock allocation!
Slow but steady
The idea here is not to make it three years into retirement and then increase your stock exposure from 25% to 75%. That is not wise.
The point is that, the further you advance in your retirement, the more you can slightly increase your stock allocation. So long as the market has not eaten you alive early in your retirement. Because, each year you progress without this happening, the sequence of returns risk on your portfolio gets lower and lower.
And it makes no sense to keep protecting your portfolio from a risk that is becoming less and less.
Instead, you can boost returns to increase the money you have to live on in retirement or pass on to heirs or charities upon your passing.
Win. Win.
But what if you do get hammered early in retirement?
Let’s say you follow this advice. But in the first years of your retirement, the market tanks, thus increasings your sequence of returns risk.
What are you to do then?!
Well, don’t panic. Markets are volatile but recessions are usually short-lived. Even bear markets.
Wait for the recession to pass. When the market is back up or at least average, give it a little more time. Then you can slowly start to increase your stock exposure.
Credit where credit is due
I got this idea from Paul Pant, host of Afford Anything, in a recent mailing and podcast with Bill Bengen.
In his mind, shifting gears is one of the 4 things you can do to boost returns with minimal increased risk.
The other 3 are:
- Diversification,
- Rebalancing your portfolio, and
- A slight small cap tilt in your stock investments
All strategies that we discuss here at The Prudent Plastic Surgeon!
Could this revolutionize your retirement plan?
Honestly, yes.
And maybe I am using revolutionize in a pretty loose manner. But for a personal finance nerd like myself, it feels justified.
Traditional advice is to minimize stock investments in your portfolio in retirement and safely withdraw 4% of that portfolio to cover annual expenses.
That is still the safest, vacuum sealed advice out there.
However, through these 3 strategies:
- Maintain variable, adjustable expenses in retirement,
- Use an average 5% withdrawal rate that varies based on market conditions, and
- Shifting gears to ultimately increase stock allocation in retirement
…you could become much more nimble and likely end up with greater returns than your otherwise would.
What you should not do?
Don’t make things overly complex. Do remember the K.I.S.S. principle.
I can certainly imagine retirees creating complex calculations to make sure they get every drop of juice from their retirement squeeze based on market conditions, micromanaging their allocation, and obsessing over expenses.
But that is not what most (or any?) one wants to be doing when they are enjoying their retirement.
So, decide if this strategy agrees with you or not. And then bake it into your written financial plan with basic guidelines that you will follow.
And what about my plan?
Well, you will see from my current written financial plan that Selenid and I still plan to use the traditional model of declining stock exposure and a 4% withdrawal in retirement.
In our case, this happens pretty much on autopilot thanks to the two funds for life investment strategy that we employ.
With that being said, we still have a long runway until retirement. As we get closer, this is a strategy that we will seriously consider!
What do you think? What do you plan to do with your stock allocation in retirement? And what is your asset allocation right now? How will it change? Let me know in the comments below!
