Risk Calibration for Retiree Portfolios

Question: I'm getting ready to retire and would like to create a worry-free, low-maintenance portfolio. What risks should I be attuned to, and how can I troubleshoot them?

Answer: Managing risk during retirement has changed a lot during the past few decades. Yesteryear's retirees enjoyed the luxury of much higher interest rates as well as pensions, so they could afford to dramatically ratchet down their portfolios' equity holdings during retirement. Why risk big losses if you didn't need to?

For today's retirees, however, fretting about short-term market movements and hunkering down in low-volatility, low-returning assets is a luxury they can't afford. Instead, they need to keep their eyes on what will be a far bigger threat--the prospect of outliving their money or having to change their in-retirement lifestyles.

With that in mind, here are some of the key risks to pay attention to as you position your portfolio for retirement, as well as how you can inoculate your portfolio against said risks.

The Threat: Longevity
It's weird to call living a good long life a risk. But today's 65-year-olds can expect to live nearly 20 years more, according to Centers for Disease Control data, and your own life expectancy may be even longer than that.

Tools for the Job--Given that long portfolio life span, all but the very wealthiest retirees need to wring some more growth out of their portfolios than cash and bonds can afford. Holding stocks is a must, but what's the right amount? Note that even the conservative version of Morningstar's Lifetime Allocation Indexes for someone retiring in 2015 has roughly one third of its assets in stocks, including foreign names, and the aggressive version holds twice that much. Somewhere between those two extremes will make sense for most retired people.

In addition to considering a higher equity weighting, pre-retirees and retirees can also consider lifestyle choices to improve their portfolios' staying power. Of course, each of these choices carries its own set of trade-offs, but the options include deferring Social Security, working longer or part-time, and decreasing in-retirement spending, particularly after market downturns. Annuities, and especially longevity insurance (namely, fixed deferred annuities), are another option for those with very long life expectancies; this article discusses these products in detail, and this one discusses some of the costs of common annuity guarantees.

The Threat: Long-Term Care
A year in a private room in a nursing facility now averages $78,000, according to a Genworth survey, and long-term care in urban settings can be far more costly than that. Given that the typical nursing-home stay averages 2.4 years, that's close to $200,000 of your portfolio's value right there.

Tools for the Job--Some of the same tools and strategies I outlined above--including holding more in stocks and reducing your withdrawal rate--also make sense if you're worried that paying for long-term care could gobble up a big share of your retirement nest egg. But the purest way to keep long-term care costs from cutting into other life goals, such as leaving money for your heirs, is to purchase a long-term care insurance policy. These policies are pricey, particularly if you buy one with an inflation component and/or if you're over 65, but they can provide invaluable peace of mind, too. This interview discusses the ins and outs of long-term care insurance.

The Threat: Inflation
Inflation looms as a particularly big threat for retired people. Retirees living off of their investments don't receive cost-of-living adjustments (except for their Social Security and possibly their pension income), so inflation can readily translate into declining purchasing power and a reduced standard of living.

Tools for the Job--As I've noted in previous articles, Treasury Inflation-Protected Securities are the most direct way to hedge against an unexpected increase in inflation, providing an adjustment to an investor's principal to keep pace with inflation. This article discusses reasonable TIPS weightings for retirees, and this one discusses TIPS' interest-rate sensitivity.

Stocks are another, indirect way to gird your portfolio against the threat of inflation. They have the potential for higher returns than bonds, and inflation will take a smaller bite, in percentage terms, out of your future purchasing power. Owning companies with a demonstrated history of dividend growth is another way to help offset the effects of inflation on your portfolio.

Finally, you might also consider a small slice of commodities in your portfolio--roughly 5%-6% at the high end, per this guidance from Morningstar's Lifetime Allocation Indexes. But if you're retired, be sure to dollar-cost average into a commodity investment rather than adding it all at once because mistiming a commodities investment can erode any long-term inflation protection benefit you hoped to gain.

The Threat: Higher Taxes
Massive government spending and unfunded liabilities could translate into higher taxes across the board.

Tools for the Job--Despite the saying that death and taxes are life's only certainties, investors actually have a lot of free, legal ways to reduce the latter. Morningstar site editor Jason Stipp and I discussed some of the key tactics investors can use, including tax-loss selling, Roth conversions, and municipal bonds, in this video. Roth 401(k)s and IRAs are also good options for tax-conscious investors seeking at least some tax-free treatment of their retirement assets. Additionally, exchange-traded funds, index funds, and tax-managed funds are superb tools for reducing the drag of taxes in your taxable portfolio.

The Threat: Volatility Turns Into Permanent Capital Impairment
Volatility doesn't equal risk, as I discuss in this article. But volatility intersects with risk if you need to tap a streaky investment when it's at a low ebb, resulting in permanent capital loss.

Tools for the Job--Retirees can mitigate that possibility by making sure they have at least a few years' worth of living expenses in true cash, the so-called bucket approach. Drawing living expenses from the cash bucket enables retirees to tolerate fluctuations in their higher-risk assets, giving the long-term sleeve of the portfolio the opportunity to rebound from market sell-offs. Noted financial planner Harold Evensky was an early proponent of creating a bucket for retirement income, then periodically filling it up. He discusses that approach in this video.  

A version of this article appeared June 2, 2011.