Rebalancing: The Swiss Army Knife in Your Retirement Tool Kit

83%/17%.

That's the current asset allocation of a portfolio that was 60% equity/40% bond when the current market rally began in March 2009, assuming that none of the positions had been added to or subtracted from over the eight-plus year holding period.

Needless to say, the portfolios of many hands-off investors are long overdue for rebalancing, reducing their equity allocations, and adding to their positions in safe securities like cash and bonds. Appropriate risk reduction is especially important for retirees and pre-retirees: Incurring big losses in a portfolio, especially early in retirement, can permanently impair a portfolio's sustainability.

The good news is that rebalancing enables retirees to reduce risk in their portfolios while achieving other worthy goals as well: meeting in-retirement cash-flow needs, fulfilling required minimum distributions, and giving to charity.

Here's a closer look at why it's worthwhile to consider rebalancing as the year winds down.

Reducing Risk The base case for rebalancing is to reduce risk in your portfolio while bringing its asset allocation back into line with your targets. As noted, stocks are taking up a larger share of many portfolios than is ideal. Meanwhile, equity valuations aren't what they were before. Shiller P/E, a gauge of market valuation that takes into account the cyclicality of corporate earnings, was 15 at the outset of stocks' current rally; today's it's almost 32. Lofty equity valuations are a key reason why market experts like Jack Bogle have suggested that investors employ muted return expectations for stocks in their portfolios.

Under a traditional rebalancing regimen, an investor scaled back on appreciated equity holdings following a market runup and move the proceeds into bonds. Of course, bonds don't compel right now, either; yields are skimpy. But if an investor's goal is to reduce risk in the portfolio, high-quality bonds should continue to serve their role as shock absorber, holding their ground or perhaps even gaining a bit in an equity market sell-off.

Meeting In-Retirement Cash Flows Despite the recent uptick in bond yields, that's thin gruel for income-starved retirees. High-quality intermediate-term portfolios are currently yielding well less than 3%; the yields you earn on high-quality shorter-term bonds are hardly any better than what you'd earn by parking your money in the bank. That has sent many retirees scrambling out on the risk spectrum in search of higher payouts--into junk and emerging-markets bonds as well as high-yielding stocks.

Despite the challenging yield environment, one key source of in-retirement cash flows--though not strictly income--is hiding in plain sight: selling appreciated securities. While traditional rebalancing involves redeploying the proceeds from appreciated positions into parts of your portfolio that haven't performed as well, you can also use your rebalancing proceeds to provide needed cash for the year ahead--or even the next two years. Retirees can rely exclusively on rebalancing to meet their cash-flow needs (what I call a "strict constructionist" total return approach), or they can use their portfolios' organically occurring income distributions, along with rebalancing proceeds, to meet their cash flows. Of course, there may be years in which neither stocks or bonds perform particularly well and aren't ripe for rebalancing; that's the key reason that all of my model in-retirement portfolios include a cash component so that the retiree doesn't have to sell depressed holdings to meet living expenses. This article discusses the pros and cons of various strategies for shaking cash flows out of a portfolio.

Raising Funds for RMDs In a related vein, retirees who are post-age 70 1/2 can and should use rebalancing to help meet their required minimum distributions from their tax-sheltered accounts like IRAs. Those distributions, in turn, can be used to fund living expenses, as discussed. One advantage of rebalancing within tax-sheltered accounts like your IRA is that your selling won't trigger any unnecessary tax bills. If you're rebalancing your retirement accounts to meet RMDs, for example, you'll owe taxes on any money you withdraw, but no more than you otherwise would. And if you're not yet retired and rebalancing within your tax-sheltered accounts--that is, moving money from appreciated positions back into depressed ones within the same account--you won't owe any taxes at all to rebalance. By contrast, rebalancing within your taxable accounts should be a last resort because selling appreciated positions is apt to trigger a tax bill. A big exception is if you're in the 10% or 15% income tax brackets; in that case, your long-term capital gains rate is 0%.

Making Charitable Contributions Charitably minded investors can also rebalance by steering appreciated positions to charity. Retirees who are age 70 1/2 or older can take advantage of qualified charitable distributions to send their required minimum distributions, up to $100,000 directly to the charity (or charities) of their choice. The virtue of that strategy versus taking the money out, paying taxes on it, and writing a tax-deductible check to the charity is that the QCD helps reduce adjusted gross income; keeping AGI down is the name of the game when determining a taxpayer's eligibility for deductions and credits.

And investors of any age can rebalance their taxable accounts and steer a highly appreciated position directly to the charity of their choice. That strategy not only reduces risk in the portfolio by scaling back highly appreciated (and potentially overvalued) holdings, but it also helps remove the tax burden that comes along with that appreciated asset. Alternatively, investors can move the money into a donor-advised fund, obtain the tax deduction, then take their time in deploying those assets to the charities of their choices. This article discusses these and other charitable strategies.