Jason Stipp: I am Jason Stipp from Morningstar. It's IRA Improvement Week on Morningstar.com, and today we're considering frameworks for thinking about asset allocation and rebalancing in retirement. This can be somewhat of a "sticky wicket" as Morningstar's Christine Benz likes to say. She is here with me today to talk about some general rules of thumb and guidelines for helping you with this.
Thanks for joining me, Christine.
Christine Benz: Jason, great to be here.
Stipp: So as you are accumulating during your working years, it seems somewhat straightforward how to arrange the assets in your retirement accounts. You have more aggressive investments and they progressively get more conservative as you approach retirement, but then you get to retirement, and a lot more complications start to creep into your portfolio plan.
Stipp: What's one way to think about and start to get a handle on how you should arrange your allocation once you reach that critical retirement time?
Benz: It's interesting. Jason, when you are in that accumulation mode, the need for asset class diversification is really sort of theoretical. You hold different asset classes to reduce volatility.
When you are in retirement, it really becomes all about "how am I going to liquidate this portfolio as I need my money?" So one concept we've talked about before, and this is one that was pioneered by Harold Evensky, the famed financial planner, revolves around buckets.
So setting up a bucket for your near-term expenses maybe for the next five years or so and that would consist mainly of cash and possibly even high-quality, short-term bonds. And then possibly staging an intermediate-term bucket that holds intermediate- term bonds, maybe even high-quality balanced funds, and that would cover you from maybe years of retirement 6 through 15, say.
And then, finally, thinking about that long-term bucket as maybe something that you would tap in years 16 and beyond of retirement or maybe that's the amount that you are growing for your children, if it turns out that you pass away sometime during those later retirement years.
I think that's a really helpful way of thinking about what goes within each bucket, what types of assets. And to me I think that's a useful way for constructing what goes into a retirement portfolio. Think about when you'll actually need the money.
Stipp: Seems like a very practical way.
Stipp: Then I guess the next question becomes, at some point you are going to use up that first bucket of cash because you will be spending it for your needs. How could you think about how money is going to flow through this bucket process?Read Full Transcript
Benz: Easier said than done; this bucket maintenance process could become a full time job for someone, if you let it. I have to say I am attracted to a highly mechanized approach, whereby someone would move money from one bucket to the next on a preset schedule maybe every quarter or once a year, if you wanted to be a little more hands-off.
And I think that has the advantage of helping you step out of asset classes, higher volatility asset classes, at varying price points. So, yes, you would be selling some at the low, which is sometimes the criticism that you hear of this reverse dollar cost averaging. But you'd also be selling some assets at a high point, like maybe right now. So, you are actually taking money off the table, which can be good thing. So, that highly mechanized approach is one way to think about it. It's an awful lot of bucket maintenance, though, maybe more than some people are bargaining for.
So, another way you could think about it is to be more strategic and plan to take money off the table and stocks when they look lofty, for example, and move money only then. Don't do it on that mechanized approach, or maybe sell things that you wanted to sell anyway for fundamental considerations and pull your cash from those investments. Maybe there was a manager change at the fund you own, or maybe you own individual stocks and they become less attractive for one reason or another. So I think that strategic idea for people who want to be more hands-on and more thoughtful about where they are pulling assets can also be effective.
Stipp: Work in maybe some valuation component there.
Stipp: It is IRA Improvement Week, and so I do want to talk a little bit about how you would layer on top of this framework the different placements within accounts--retirement accounts--and where you might put some of these assets.
There are some rules of thumb because some of them are tax advantaged and some of them have different requirements for how you're taking money out; it gets a little complicated. What are some of the rules of thumb about asset location in these accounts and how might that layer over this bucketing system?
Benz: Yes, as if the whole bucketing system weren't confusing enough. You do have to think about taxes. So the standard rules of thumb would be that taxable accounts would be your go-to-accounts for starting off in terms of funding retirement expenses, and the key reason is that those are your most costly assets from a tax standpoint.
So you'll pay income tax on any income that your bond portfolio or whatever your cash might be kicking off at this point, and then if you have any capital gains, you'll owe taxes on that as well. So those are usually first priority when liquidating a retirement portfolio--that's definitely something to think about. Whereas your tax-advantaged accounts and certainly your Roth accounts would tend to come last in the pecking order, and the key reason is that the tax benefits are really quite generous and so you want to stretch them out as long as you can over your investing life.
Stipp: I know you've written about this before, there are also some practical implications and some rules, for example, on traditional IRAs that cause you to have to be a little bit more thoughtful and maybe really take a closer look at exactly what is in some of these retirement accounts.
Benz: Right. So I guess, if you're thinking about the standard rule of thumb, you would save those Roth assets for the last and you might think, "A-ha, then I can put all my stocks in my Roth accounts because I'm not going to need to be drawing on this money."
But the fact is there might be years during your retirement when you may want to pull money from those Roth accounts--maybe you are in a particularly high tax year for whatever reason--you will be glad you have some short-term assets carved out in that Roth account.
By the same token, if you have other, say, IRA assets or a company retirement plan, you'll also need to keep cash at the ready to fund your RMDs once you hit age 70 1/2.
So I think flexibility is really key. You can keep these rules of thumb as overarching principles, but it helps to stay nimble and give yourself as much flexibility as you possibly can.
Stipp: Well, it sounds like a pretty complicated topic, but some very useful rules of thumb. Christine, thanks for joining me today.
Benz: Thank you, Jason.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.