Retiring Soon? Make Sure to Check Your Asset Allocation

Ivanna Hampton:

Welcome to a special episode of Investing Insights. I’m your host, Ivanna Hampton. Today’s discussion will focus on portfolio makeovers and how to spot common pitfalls. This year’s market volatility has rocked many portfolios. Some investors might be taking a peek at their account balances and wondering what to do. Morningstar Inc’s director of personal finance Christine Benz has recently released her Portfolio Makeover Week webcast – “5 Portfolio Pitfalls and How to Fix Them”. Christine is joining Investing Insights to share timely advice and an excerpt from her webcast.

Hi, Christine.

Christine Benz:

Hi, Ivanna.

Hampton:

You've recently released your Portfolio Makeover Week webcast, and what did you think was important to address this year as we've watched the markets tumble?

Benz:

Well, so many things because people who are writing in for these portfolio makeovers, and I'm sure people reading them, are concerned about the wherewithal of their portfolios. If they're getting close to or in retirement, they want to make sure that they have adequate savings, that their spending rate isn't too high. So we wanted to address that concern, which tends to just come up again and again. We also wanted to address what asset allocations should look like, given that we have had this really worrying time in the stock market and the bond market. We share different portfolios with an eye toward giving investors some peace of mind in evaluating their own plans and recognizing that, if they do need to make changes, they can use Morningstar.com, use the tools, and articles, and other resources on the site to help engineer those changes.

Hampton:

Some investors are probably looking at their portfolios right now and seeing numbers that are making them a bit uneasy. How does your webcast help investors identify the next steps in making over a portfolio?

Benz:

Right. We wanted to address some of the key portfolio pitfalls that we observe, that I observe when I review portfolios, and not just assess and address what those portfolio pitfalls are but also talk about how you can make them better. I focused a couple of the points on people who are in or close to retirement. We looked at people's withdrawal rates and helped figure out how to assess the sustainability of a withdrawal rate, how to get a withdrawal rate back on track. We also looked at people's asset allocations who are approaching retirement: Are they appropriate given their portfolio spending?

So we discussed those issues. We discussed portfolio sprawl, which is a common issue that I see when I look across portfolios, where people simply have too many accounts, too many holdings. And we talk in the webcast about how you can skinny down the number of holdings. I think that one of the main takeaways I get from people who submit their portfolios and that I work with on these portfolio makeovers is they're always incredibly pleased with how streamlined the After portfolio is. So those are some of the key things that I talked about in the webcast.

Hampton:

How does someone's age play a role in reworking a portfolio?

Benz:

It's crucial. I think about time horizon, proximity to needing your money, as being so influential in terms of dictating that portfolio's asset allocation. So for people who are in their 20s, 30s, or 40s, those are folks who can afford to take quite a bit of risk in their portfolios. They should have equity-heavy portfolios because they aren't going to need those assets anytime soon. They may have shorter- and intermediate-term goals, but for the most part, for their retirement savings, those can be invested quite aggressively. On the other hand, older adults who are getting close to or are even in drawdown mode, where they're actively spending from the portfolio, that's where you have a greater need for safe assets in the portfolio. But I do think time horizon is an absolutely essential ingredient when figuring out what that whole portfolio should look like.

Hampton:

Reworking a portfolio might entail paying some taxes. What should people know before they adjust their portfolios in the effort to reduce potential drag?

Benz:

That's such an important point. Many times, I'll suggest changes that affect the taxable portfolio, so non-tax-sheltered assets. And in that case, it's absolutely crucial to be deliberate about making any of those changes because you wouldn't want to trigger a big tax bill simply to get the portfolio's positioning correct. Ideally, if changes are in order, most of those changes could happen in the tax-sheltered accounts. So, for example, if you need to dramatically rework a portfolio's asset allocation, if you can concentrate those energies within the tax-sheltered accounts, the good news is that you can make changes there without triggering a big tax bill.

Hampton:

All right. Well, thank you, Christine, for helping us navigate this time.

Benz:

Thank you so much, Ivanna.

Hampton:

As promised, we’re going to play part of Christine’s webcast where she focuses on pitfall number one – “A Too-Aggressive Asset Allocation Prior to Retirement.”

Benz:

This is just a look at our X-Ray functionality, looking through a portfolio. You can see in the case of this particular portfolio, it's very heavily tilted toward stocks, U.S. stocks in particular. This is not at all uncommon, particularly given that until very recently we had seen U.S. stocks outperform most asset classes. And it's easy to see why investors often let their equity holdings ride, partly because we have had such very strong performance from stocks over the past decade.

This slide captures with the green bars what the S&P 500 would have returned on a predividend basis, and that bright aqua bar is what the S&P 500 returned over the past decade factoring in dividends. You can see that it handily outperformed the lines at the bottom of this chart, which depict the return that bond investors earned over the same decade. And so, you can see that many investors, if they've just been letting well enough alone in their portfolios, have ended up with more equities than they might consider ideal, especially if they're getting closer to retirement. This isn't such a big deal for people who are in their 30s, 40s, even early 50s. But for people who are getting close to drawing upon their portfolio, having too much in equities can be problematic.

What we've seen so far in 2022, you don't need me to tell you this, is that equities and bonds have simultaneously performed poorly, and that has left a lot of investors who were approaching retirement scratching their heads about what to do about how their portfolios should be positioned. This pattern has been quite unusual in modern market history, where bonds had a really nice diversifying effect for stocks where when we saw stocks fall in periods of bear markets, we often saw bonds at least hold value or maybe even gain a little bit of value. We didn't see that this time around in part because interest rates are bugging both stock investors and bond investors. Rising interest rates depress the value of already existing bonds, where investors who hold such bonds say, "Well, never mind those bonds. If newer bonds are coming online with higher yields attached to them, I want them instead." That pushes down bond prices. Stock prices have also been affected by rising interest rates, in part because there's an expectation that if rates continue to rise that they will begin to affect the economy with implications for corporate earnings. And so, that's why both stocks and bonds have fallen simultaneously this time around.

You can see that if an investor were coming into a year like 2022 and getting ready to retire, he or she might be scratching their head about where to go for cash in a tough year for both stocks and bonds. And incidentally, non-U.S. stocks haven't been any great shakes so far in 2022. In fact, they've actually underperformed U.S. stocks. So, an investor who had a fairly slight position in cash and was actively drawing upon that portfolio might be wondering where to go for cash. So, this is just an illustration of why it's important to make sure that your portfolio has adequate liquidity, has adequate allocations to very safe assets that you could draw upon in this type of scenario. If an investor spends through that $50,000 cash allocation, he or she may not have an easy source of additional funds to turn to. I suppose bonds would be next in the queue because they've performed the least poorly relative to the other asset classes, but nonetheless, it's not a great position to be in.

And that's why I'm such a big evangelist for the idea of using a bucket type strategy, or thinking about a bucket type strategy as you decide how to allocate your assets for retirement. So, just to illustrate how a bucket approach would look in practice: Bucket 1 would hold portfolio withdrawals for years one and two of retirement. That would be a highly liquid portion of the portfolio, where you'd have mainly cash assets or entirely cash assets, assets with FDIC guarantees, assets that today promise a somewhat higher return than they did even a year ago. But you don't want to overdo that Bucket 1 because on an inflation-adjusted basis, of course, you're in a losing position. But the idea is that you're at least stabilizing the cash flows for years one and two of your retirement.

Bucket 2 is a high-quality fixed-income portfolio, mainly. You might hold a little bit of dividend-paying equity exposure with this portion of the portfolio, and this would hold roughly eight years' worth of portfolio withdrawals.

And then, Bucket 3 is the growth engine of the portfolio. But the idea is that it's holding assets for years 11 and beyond of retirement. So, it's a globally diversified equity portfolio. That's where I would hold any aggressive nonequity positions that I happen to have in my portfolio. If I had commodities, if I had a position in precious metals or gold, if I had high-yield or emerging-markets bonds, for example, I would think of them as belonging in that equitylike bucket of my portfolio. But I think this is just a neat strategy for thinking about how much to drop into each of the asset classes as retirement approaches.

This is a sample ETF Bucket portfolio using the same general structure. We're assuming a $750,000 portfolio. We're assuming a $30,000 annual spending rate from that portfolio. For that cash bucket, for that Bucket 1, we've got $30,000 x 2 going into that portion of the portfolio. Bucket 2 is that high-quality fixed-income portfolio accounting for another eight years' worth of those portfolio withdrawals, and it's stair-stepped by risk level. So, you can see at the front end of that bond portfolio, we've got some low-risk bond types and then an intermediate-term bond fund, which will have more volatility and, indeed, real losses in 2022. And then Bucket 3 is the growth engine of the portfolio. It's mainly a diversified equity portfolio with a little dash of high-yield bond exposure. But that's how this would look with an actual portfolio. I've created a lot of different model portfolios on Morningstar.com, many of which are organized around this general bucket framework.

Just a quick note on bonds. We talked about why bonds have been so disappointing so far in 2022. I grabbed this slide from my colleague, Amy Arnott, that looks at the magnitude of losses in bonds, and I think that really that's the reason to keep the faith in your fixed-income investments: that when we look over market history, we see that stocks and bonds tend to have losses in a similar ... the periods in which they have losses have been similar, but the magnitude of those losses have been different and much worse for equities than bonds. So, whether you're looking over a quarterly time horizon or an annual time horizon, the magnitude of those fixed-income losses, at least over market history, has been much less than has been the case with equities.

The point of this slide is to illustrate that if you are an investor who is approaching retirement and you find yourself with a lot of equities in your portfolio, I think the key thing to remind yourself of is that even though you didn't catch the absolute top in terms of derisking your equity portfolio, you've nonetheless had a really good run in your equity portfolio most likely. Assuming that you've been a longtime holder of stocks, you've had returns that are in line with or even better than, in the case of the 10-year return, what historical averages have been with stocks. So, if you're looking at your portfolio today, if you're in drawdown mode, if you're in retirement or you're getting close to retirement, I don't think that there's shame in derisking your portfolio even if you didn't manage to catch the absolute top of the stock market. You still have an enlarged stock portfolio because stocks have been so good for so long.

If you are derisking in your preretirement years, just a couple of tips to bear in mind: One is that the starting point for deciding your in-retirement asset allocation is to look outside your portfolio. Start by thinking about income that you'll get from Social Security or from a pension and use that to determine how much you'll need to withdraw from your portfolio. Start by maximizing those nonportfolio income sources. That in turn can help lessen your portfolio withdrawal needs. It's also important to mind the tax consequences of any repositioning, especially if you are lightening up on equity holdings. If you need to make changes to get your asset allocation more in line with where you want it to be, concentrate the selling in your tax-sheltered accounts where you won't owe taxes to do that repositioning.

At the same time, I think it's helpful to bear in mind where you will go for your withdrawals in retirement. So, taxable assets when we think about the queue that you might use for retirement spending, the order in which you would deplete your various accounts, taxable assets often go first. So, if that's your strategy, you would want to make sure that you have ample liquidity in your taxable account. It's also helpful to not wait until the year before retirement or the six months before retirement to make these changes. Ideally, you would be taking a little bit of risk off the table in the years leading up to retirement rather than waiting until the last minute.

And finally, just another note on the role of safe assets and the interplay with inflation: As we've had inflation coming on strong so far this year, to me, that really underscores the value of not overdoing your allocation to safe assets. Even though they've been the only thing that have held their ground so far in 2022, this isn't a typical year. So, I think you want to be careful not to overdo those safe assets because the inflation will eat away at your purchasing power there.

Hampton:

Well, I hope what you learned can help you improve your portfolio. I want to thank Christine again for her time today and the work she put into her webcast. We’re going to release other videos from her webcast on Morningstar’s YouTube channel. So, subscribe to make sure you don’t miss out on how to fix other pitfalls. Before I go, thanks to podcast producer—Jake VanKersen. I got to thank you for watching our special episode of Investing Insights. I’m your host, Ivanna Hampton. I’m a senior multimedia editor at Morningstar. Take care.

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