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Financial Advice

Do Investors Need to Reset Their Investment Strategy in Retirement?

Considering Social Security as part of the asset allocation could prove beneficial.


Individuals can claim Social Security retirement benefits as early as age 62, but waiting until full retirement age will deliver the full monthly benefit. If seniors delay collecting benefits beyond their full retirement age, their benefit will increase by 8% per year of delay (two thirds of 1% per month) up to age 70. Beyond age 70, benefit amounts no longer will increase.

There’s one more twist: If an individual earns certain amounts of money while collecting Social Security benefits before full retirement age, their benefits will be decreased by $1 for every $2 earned above the annual limit ($19,560 for 2022). This “earnings test” is more lenient during the calendar year of reaching full retirement age.

My usual advice to midlifers:

  • If you plan to continue to work, don’t take Social Security until at least your full retirement age.
  • If you are retiring before your full retirement age and need the money, take Social Security early.
  • If you do not need the benefits early, wait until at least your full retirement age to claim Social Security.
  • If you have enough savings that you are not reliant on Social Security and expect to live at least into your 80s, delay benefits until age 70.

Morningstar research has concluded that people who live until average life expectancy come out substantially ahead by waiting beyond their full retirement age to start Social Security, even if that requires tapping other investments to do so.

Resetting the Investment Strategy

Should seniors’ investment strategy change in retirement?

The “old” advice was to move to a more conservative allocation—but those were the days of retiring at age 65 and not living more than 10 years! With longer life spans and the likelihood of leaving assets to heirs, a portfolio that is too conservative might not even keep up with inflation. Thus, allocation should be reviewed at retirement.

While a retirement investment strategy might stay the same, the way in which it is implemented might need to change. Considering Social Security as part of the asset allocation could prove beneficial. Essentially, Social Security provides a lifetime annuity with inflation adjustments. Similar to a fixed-income investment in that it produces regular income with no principal appreciation, Social Security provides a risk-free “safe withdrawal rate.”

It could be argued that Social Security can represent some (or all) of a retiree’s fixed-income allocation in a retirement portfolio. Investors who incorporate this perspective into their investment strategy have several options. They can:

1) Create an allocation equivalency.

2) Move to a more aggressive allocation.

3) Switch to a bucket strategy.

Creating an Allocation Equivalency

Treating Social Security as a fixed-income investment requires converting the income stream into an equivalent asset holding. The presumed rate of return can be based on current average fixed-income returns or an appropriate safe withdrawal rate.

For example, a 4% return rate for a monthly annuity of $3,345 starting at full retirement age would be the equivalent of an investment principal of about $1 million. Thus, an investor with a $5 million portfolio (not including Social Security) should now consider themselves holding a $6 million portfolio. If their target allocation is 60% stocks/40% bonds, their equity allocation should rise to $3.6 million from $3 million and their fixed-income allocation to $2.4 million ($1.4 million bonds, $1 million Social Security) from $2 million.

In other words, treating Social Security as a fixed-income investment will require moving $600,000 of fixed-income assets in the portfolio to equity. Not doing so would leave a 50/50 allocation (the $1 million Social Security equivalent would be added to the $2 million fixed-income allocation), more conservative than the desired 60/40 split.

Note that an investor choosing this method will need to accept higher volatility from the investment parts of the portfolio. Although overall stock/bond allocation is approximately 60/40 when we consider Social Security part of the fixed-income allocation, the investment portfolio itself will now be 72/28.

Moving to a More Aggressive Allocation

As opposed to calculating a numerical equivalency, it might be reasonable to simply move to a more aggressive allocation in the investment portfolio.

By acknowledging the significant fixed cash flow from Social Security, the remaining portfolio can be more heavily weighted to equities, thus providing greater long-term inflation protection. Note that starting Social Security early would provide less from Social Security, which might be treated as a smaller fixed-income investment, resulting in a smaller increase in equities; by contrast, waiting for Social Security could increase the fixed-income allocation and thus lead to a more aggressive equity position.

Switching to a Bucket Strategy

Many investors like to compartmentalize cash inflows with cash outflows. Because Social Security delivers guaranteed monthly income, it might be appropriate to allocate Social Security income to nondiscretionary expenses such as mortgage payments, rent, insurance, food, and so on. Cash flow from investments can be allocated to discretionary expenses such as travel, entertainment, home improvements, and so on. Allocating expenses this way allows for a more aggressive investment portfolio because discretionary expenses can be adjusted based on market ups and downs.

Mixing in IRA Distributions

Another aspect investors nearing retirement need to consider are IRA distributions.

In general, savers can begin taking traditional IRA distributions at age 59½ penalty-free and must begin required minimum distributions, or RMDs, at age 72. The annual RMD amount is based on age, starting at about 3.65% of the account balance. Withdrawals from pretax IRAs are taxed in full at ordinary tax rates.

Many IRA owners avoid nonrequired distributions, then simply draw down their balances according to the RMD tables. These withdrawals are taxable, so RMDs increase taxable income and possibly cause a greater percentage of Social Security benefits to be taxable. Medicare premiums also could increase with greater income.

Considering these details, it sometimes makes sense to begin taking IRA distributions at retirement rather than waiting until age 72. By doing so, income could be spread over a greater number of years, thus reducing long-term tax liabilities. If the distributions are not needed for living expenses, it might be better to use them for Roth conversions, which can be beneficial in lowering RMDs and minimizing future taxes.

Respect for Roth Conversions

I consider the Roth IRA to be the holy grail of tax planning. Funded with aftertax dollars, these accounts grow tax-free and withdrawals can be tax-free—meaning that investment income might never be taxed. Additionally, there are no required distributions from an owner’s Roth IRA.

For those in high tax brackets, paying tax on IRA distributions now can be a tough pill to swallow. Nevertheless, eliminating future taxation at possibly higher expected tax rates on withdrawn principal and growth, as well as eliminating RMDs, can provide great benefits. Converting a large IRA balance to a Roth IRA not only will allow that amount to subsequently grow tax-free, but also the tax paid can reduce the amount subject to estate taxes.

Consider this hypothetical example:

Joe owns an IRA and is retiring at age 64. He has enough cash flow from taxable investments to cover living expenses without starting Social Security. With minimal income and deductions for personal exemptions, mortgage interest, taxes, and charitable contributions, Joe has a pre-Roth conversion taxable income of negative $50,000.

Joe’s current traditional IRA balance is $1 million. If Joe converts $90,000 per year to a Roth IRA, the annual federal tax would be only about $4,600 per year. Assuming an annual growth rate of 4%, after six years Joe’s traditional IRA would be reduced to about $640,000, while his Roth IRA will have about $620,000—at a total tax cost of less than $28,000!

Then, at age 70, Joe can start taking Social Security benefits and receive the maximum amount, lifelong. However, by waiting two more years to take RMDs and continuing Roth conversions for those two years, the traditional and Roth IRA balances could grow to about $690,000 and 670,000, respectively. RMDs will start at approximately $25,000 rather than about $50,000.

Know Where to Hold Them

Detailed tax planning will be required to determine optimal Roth conversion amounts each year.

Additionally, care must be taken with location optimization—placing particular investments in different accounts (taxable, traditional IRA, and Roth) based on tax characteristics.

Typically, fixed income is placed in a traditional IRA because 1) tax is deferred on the interest income; 2) when distributions are taxed at ordinary rates, the interest income would have been taxed the same way (as opposed to taxing appreciation withdrawn from traditional IRAs at ordinary rates); and 3) fixed income is a lower-return asset class, which results in lower RMDs.

Potentially appreciating investments such as U.S. stock funds should be placed in taxable accounts because 1) tax is deferred on unrealized appreciation; 2) when sold, appreciation is taxed at capital gains rates; and 3) appreciated assets can pass to heirs free of income tax.

High-return investments, such as emerging-markets equities, are typically held in the Roth IRA because 1) the growth will never be taxed, 2) there are no RMDs, and 3) as Roth investments are typically the last to be tapped, the account can withstand volatility.

The bottom line is that careful investment planning is needed to optimize tax savings in a portfolio. Such asset-allocation planning should move to the forefront if Social Security benefits are considered a portion of a fixed-income allocation, especially if delaying Social Security significantly increases the amount of guaranteed, lifelong, inflation-protected fixed income.

This article was previously published in the August 2022 issue of Heather Schreiber’s Social Security Advisor and is republished with the permission of Smart Subscriptions, LLC.

The opinions expressed here are the author’s. Morningstar values diversity of thought and publishes a broad range of viewpoints.

The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.

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