Why Retirees Need a Balanced Portfolio

A Must-Know for Retirees: How to Maintain a Balanced Portfolio

Christine Benz: These are various asset allocations, various combinations of stocks and bonds and cash, that someone might have used during their retirement drawdown period. And what you can see is that 100% stock portfolio did, in fact, support the highest withdrawal rate in market history. So, if we look at 30-year time horizons over market history, if you had that 100% equity portfolio, and you hit it exactly right, you could have taken a 6.5% withdrawal over that time horizon, starting withdrawal over that time horizon.

The problem with that all-equity portfolio is that if you hit it exactly wrong, and you picked a terrible time to retire with that equity-only portfolio, the safe withdrawal amount would have been meaningfully lower. In fact, it would be fully half of the highest safe withdrawal amount. So, this research that looks at historical data and was compiled by my colleague John Rekenthaler very much points to the value of having a balanced allocation. So, you can see that the portfolios that have at least some fixed-income assets in them tended to deliver a pleasing safe withdrawal amount, neither terribly low nor terribly high. And of course, high is good, but the idea is that you would like to try to improve the odds and to ensure that you can take out the most from your portfolio as is possible. The historical research points to the value of balance.

Higher Yields Point Toward Value of Balance

And indeed, when we look at our own research, which takes a forward-looking view of what would be safe withdrawal amounts, we come to a similar conclusion. So, over those very short time horizons, so for older retirees, for example, we can see that actually, based on our research, based on our Monte Carlo simulations, they’re actually better off with more-conservative-tilted portfolios, so portfolios that have as little as 30% or even 20% in equities. Whereas people who are retiring with more typical time horizons, so people retiring with 25- or 30-year time horizons, are better off with portfolios that are balanced in nature. The 60/40, the 50/50, even the 40/60 portfolio tends to support the highest safe withdrawal amount. And the reason is that even though the expected return on stocks is much better, and that cuts across stocks of all types, what we see is that the variability of bond returns is much more predictable, much more reliable, and that’s what we’re seeing in the right-hand column here, where we’re looking at the expected standard deviation of returns for each of these asset classes.

Stock Returns Are Higher but More Variable

You can see that, yes, equity returns—expected returns—are better, but the variability of their returns, the volatility of their returns is also much higher. On the other hand, bonds and cash, you have a lot more certainty of the return that you might earn, in part because of that tight correlation between starting yields and subsequent returns that I talked about earlier, that we just know that with higher yields, bond investors have a much better shot of earning a safe return than is the case with investors who roll the dice with very equity-heavy portfolios.

Bucket Approach Provides Balance

This is just a quick look at the Bucket approach, which I think very much reinforces the value of having balance into the portfolio that you bring into retirement. Many of you have probably heard me talk about this Bucket strategy before. I always take pains to credit Harold Evensky for his work in this area, where years ago, he and I were talking, and I asked him what he did with his clients, and he said, “Well, I just used this cash bucket that I bolt on to the long-term total return portfolio, and that gives my clients a lot of peace of mind with what might be going on with the longer-term components of the portfolio.”

So, in a simple Bucket setup, we’re setting aside one or two years’ worth of portfolio withdrawals in cash investments. We’re not taking any risks with this portion of the portfolio. We are subject to inflation risk, but we’re not overallocating to it. So, we’re just holding a couple of years’ worth of portfolio withdrawals. And then, with the rest of the portfolio, we’re just stepping out a little bit on the risk spectrum. So, with Bucket 2, we have a high-quality fixed-income portfolio mainly, and I would stairstep that portion of the portfolio from very conservative, high-quality short-term bond funds to holdings that are a little bit more aggressive. So, there I would consider holding intermediate-term bonds, a component of Treasury Inflation-Protected Securities. But the idea here, the core idea here is that with Bucket 1, your cash bucket, and Bucket 2, which is your high-quality fixed-income piece, you could have Armageddon with the stock market. You could have very terrible performance with your stock portfolio, and you would still have that 10-year runway of fairly safe returning assets that you could spend through if you needed to.

In many other market environments, you may actually want to be pulling from appreciated equity holdings. In fact, that was my guidance to retirees in that period from 2019 through 2021, was that their best source of cash flows was hiding in plain sight in their appreciated equity holdings. But in some market environments like 2022, the Bucket system can really come in handy because you have those cash flow reserves sitting there for you. You don’t have to disrupt fixed income, and you certainly don’t have to disrupt equities. So, that’s the basic Bucket structure. Inherently, it’s a balanced approach. And many retirees who run through this exercise with their own portfolios where they’re looking at their anticipated portfolio withdrawals and then dropping X amount into each of the buckets, frequently, retirees will come up with more or less balanced portfolios after going through this exercise.

Sample In-Retirement Bucket Portfolios

This is just a sample in-retirement Bucket portfolio, a very plain-vanilla one composed of exchange-traded funds. So, we’re assuming that retirees are spending $60,000 from a $1.5 million portfolio. So, they’re using a 4% withdrawal rate, a little higher than we would suggest might be sustainable. But for the sake of this illustration, they’re taking out $60,000 a year. So, you can see that they’ve organized the portfolio in the way that I’ve just discussed, where they have a couple of years of portfolio withdrawals in that cash bucket, Bucket 1, another eight years, or $480,000 worth of portfolio withdrawals, in that high-quality diversified fixed-income portfolio, and then Bucket 3 is the growth portfolio for years 11 and beyond. For them, that’s the bulk of their portfolio. They have a globally diversified portfolio. They have a little bit of emphasis on dividend growth stocks, which came through 2022 with flying colors. If you’re more minimalist, if you’re kind of a Boglehead three-fund portfolio person, you might reasonably just have a total market index, total international index, and total bond market, even though you’ll miss out of a little bit of nuance, you would have the basic core constituents of a Bucket strategy, but you’d also want to have that cash reserve set aside to meet your spending needs for the first couple of years of retirement.

But Buckets 1 and 2 Carry a Substantial Opportunity Cost

The key thing to note on the Bucket strategy is that there is an opportunity cost. In fact, I think of Bucket 1, that cash bucket, is a little bit of a luxury good, and the size of that cash bucket really depends on how well-situated your plan is. If you feel like your plan is in terrific shape, you’re not worried about your spending, you’re not worried about outliving your resources, you could reasonably hold a little bit more in Bucket 1. But for many other folks, I think they want to be careful to not overallocate to Bucket 1, mainly because, on an inflation-adjusted basis, you’re probably in the red with this portion of the portfolio.

So, there are some ways to skinny down that Bucket 1. One would be a series of steps that would be advocated by Wade Pfau. He’s a leading retirement researcher. One would be to hold some sort of reverse mortgage that you could tap in a pinch, kind of a standby reverse mortgage. If you have some sort of a permanent life insurance policy that has cash value, you could potentially tap those cash reserves on an as-needed basis. And you could potentially use some sort of a short-term annuity product to fill that role as well.

Alternatively, another idea to avoid the opportunity cost, to avoid that big drag of Bucket 1 would be, if you came into retirement and encountered a really bad market environment, that you could spend through that Bucket 1, spend through potentially part of Bucket 2, and then just not fully replenish those buckets once they were depleted. That’s the reverse glide path idea that some retirement researchers, including Michael Kitces, have talked about.

Another idea, another way to tweak that basic Bucket system that I’ve talked about, is for retirees to potentially shrink down Buckets 1 and 2 a little bit. So, Bucket 1 might just cover you for one year’s worth of portfolio withdrawals and Bucket 2 might just hold enough high-quality bonds to tide you through, say, five years’ worth of portfolio withdrawals. So, you can certainly make some adjustments to those allocations to the safer buckets in an effort to reduce the opportunity cost of having too much in safe assets.

Watch “5 Must-Knows About In-Retirement Spending” for the full webcast from Christine Benz.