Step 4 - Hypothetical vs Actual

Before we begin, I wanted to let you know about an important development. A week or so ago TD Ameritrade joined Schwab in the so-called “race to zero”. Fidelity jumped on the bandwagon in recent days too. The result is that all three major online brokerage firms now charge zero trade commissions to buy and sell stocks and exchange traded funds. This is great news for investors.

This week’s post is part of a series about backing into your asset allocation, a multi-step process to 1) determine your annual spending needs in retirement; 2) use history as a guide to get a feel for how long a stock market downturn could last; 3) figure out how much to invest outside of the stock market to provide spending power during a downturn; and 4) how to reconcile all of this with the reality of your portfolio and tolerance for risk.

As a reminder, our simplified example looks at a couple of retirees with a planned $15,000 spending deficit next year. They were planning to spend $90,000 total, including basic needs of about $75,000 plus $15,000 for discretionary spending (travel, painting the house and landscaping). They were expecting $75,000 of income. They’ve looked ahead and assume this spending rate will continue for the foreseeable future but want to cover themselves should the stock market go through a multi-year whacky phase.

Our couple decided they’d like to hold four years’ worth of spending deficits outside of the stock market. They opted not to use four years of total spending ($90K X4 = $360K) in their calculation because it was way too high relative to their $500,000 investment portfolio. But they also felt four years of $15,000 deficits (or $60K) was too low, leading them to round up to a target of $100,000, or 20% of their current portfolio.

Comparing this to their actual portfolio they find they currently have 40% invested outside of the stock market. This was the result of a “moderate” score during a risk tolerance questionnaire they completed suggesting a portfolio mix of 60% in stocks and 40% in bonds and cash. This is different from their work to back into their allocation. Which process is correct?

Interestingly, both processes are correct and important, but they each tell you different things. Risk tolerance questionnaires help you understand how likely you are to stick with an investment program through market turmoil. If you’re a cautious person who prefers less risk, the questionnaire will label you as “conservative”. If you’re a shoot-the-moon risk taker the questionnaire will call you “aggressive”, often with a spectrum of labels in between. This is helpful while you’re saving for retirement but isn’t meant for when you’re actually retired and spending down your savings. It’s too simplistic to be used by itself.

Going back to our couple, they now realize their current stock and bond mix is probably leaning conservative for them since they’d have twice as much in non-stock investments as they’d need (or more since they rounded up). They ask their humble financial planner to run both scenarios through a Monte Carlo analysis within their retirement plan. Having done so, they learn that while they can afford to have less in stocks and be more conservative, they could see more growth potential over time by doing the opposite.

What should they do? I generally recommend folks err on the side of caution when it comes to investing during retirement. But at the same time, it’s important not to shoot yourself in the foot by being overly conservative.

For example, say our couple was very risk averse and already had most of their retirement money in cash and short-term bonds. Maybe they hadn’t done much planning and investing but had simply saved diligently during their working years. Now that they’re retired, they likely need to earn more than their current investments will provide. This will help fend off inflation over time and, hopefully, provide for a larger financial cushion later in life. In this situation, backing into their asset allocation could help them feel more comfortable with stock market risk if they knew they had many years of spending deficits held in safe investments.

What kinds of investments are best for this portion of your portfolio? While there are different short-term options, it’s best to keep things simple. Certificates of deposit are a good option, as are money market mutual funds. These can be mixed with short-term bond funds from Vanguard, State Street, or iShares that hold bonds of high credit quality and have a duration at or lower than the period you’re trying to protect, such as four years in our example.

What’s not appropriate for these dollars? Real estate investment trusts (because they’re stocks), high yield or “junk” bonds, bonds or CDs that are longer-term, and anything else that restricts your ability to quickly access cash within your timeframe. By the way, you can own all of these within the rest of your portfolio, just not within this portion.

Ultimately, backing into your allocation offers an alternative way to think about your portfolio mix. It also offers a useful process for budgeting risk during retirement. Done right, this process should help you stick to your plan for the long-term regardless of what the markets throw at you.

Have questions? Ask me. I can help.