Retirees and Preretirees: It’s Not Too Late to Derisk Your Portfolio

For investors hurtling toward retirement, sitting tight with stocks has been the path of least resistance in recent years. Stocks, especially US names, have soundly outperformed bonds: The Morningstar US Market Index has gained nearly 12% over the past decade, versus a 10-year gain of just 1.4% for the Morningstar US Core Bond Index. And until quite recently, fixed-income yields—the chief return engine for bonds—had stalled out at ultralow levels since the global financial crisis. Very low yields limited bonds’ return potential and gave them precious little cover when bond prices contracted amid the Federal Reserve’s rate-tightening campaign in 2022. Taken together, those forces gave many preretirees and retirees a “why bother?” attitude toward bonds and reinforced the merits of standing pat with equity-heavy portfolios.

Recent events should serve as a wake-up call to take some risk off the table and give bonds a closer look, however. Stocks scraped new highs in mid-February of this year but nose-dived due to economic uncertainty in the ensuing month, officially entering correction territory on March 13. (A correction is defined as a stock market loss of 10% or more.) Bonds, meanwhile, have remained pretty resilient amid the equity volatility and uncertainty about economic growth, underscoring their utility as portfolio shock absorbers. The fact that bond yields are now higher bolsters their long-term return prospects, too.

Stocks have recently recovered a bit of ground, providing preretirees and retirees with an opportune time to scale back equity exposure and plow the proceeds into safer assets like cash and high-quality bonds. Here’s a look at the merits and logistics of derisking a portfolio as retirement approaches.

The Benefits of Derisking

The key benefit that bonds confer to a retirement-decumulation portfolio is their lower volatility. The standard deviation—a measure of volatility—of US bonds has been just a third of the US stock market’s standard deviation over the past decade. In other words, even though bond returns are apt to be lower than stocks’, bond returns are much more reliable. In retirement portfolios, holding a component of lower-risk assets mitigates what retirement researchers call “sequence risk”—the prospect of encountering big portfolio losses early in retirement. If a retiree is spending too much from a portfolio that has lost value, that leaves fewer assets in place to recover when the market eventually does. In turn, that imperils the likelihood that the portfolio will last for the whole 25–30 years of retirement. And because equity-heavy portfolios have the potential for bigger losses than balanced or more bond-heavy ones, that leaves them more vulnerable to sequence risk, as Jeff Ptak noted in a recent article. People are most vulnerable to sequence risk in the first five years of their retirement, and new retirees with equity-heavy portfolios are the most vulnerable of all. Our retirement income research corroborates that thesis: Largely because of reduced sequence risk and the substantially lower volatility of bonds, balanced portfolios of stocks and bonds allow for a higher starting withdrawal percentage over a 30-year horizon than more equity-heavy ones.

In addition to bonds’ lower volatility, today’s higher yields point to better return prospects from bonds over the next decade than was the case a few years ago. That’s because bonds’ starting yields and subsequent returns are closely correlated. The yield on 10-year Treasury bonds sat at about 50 basis points in the summer of 2020, but today it’s about 4.2%. Not only does that improve bonds’ forward-looking return prospects, but higher yields also give bondholders more protection against price declines than they had when yields were ultralow. (Even if a bond or bond fund’s price declines, the investor still receives their yield.)

There’s a time-period-specific reason to consider bonds, too. With worries about a slowing economy looming over the market, high-quality bonds will tend to be particularly well situated. While inflation related to tariffs remains a wild card for fixed-income assets, high-quality bonds have generally performed well in weakening economic conditions. In an examination of asset-class returns in various recessionary periods in US history over the past 100 years, we found that stocks frequently contracted during such periods. Meanwhile, bond returns were reliably positive in recessionary environments.

Finally, for retirees who worry that they’re too late to derisk because market volatility is already underway, they shouldn’t sweat the timing too much. Stocks have recovered most of their recent losses, and this recent downturn has been modest relative to biggies like the global financial crisis, when stocks dropped about 60% from peak to trough. That means that investors decreasing their equity exposure now shouldn’t fear selling themselves out at a terrible time. And in any case, stocks’ extended run leaves many portfolios equity-heavy today. A portfolio that was 60% stocks/40% bonds five years ago would be nearly 80% equity today, without any additional purchases of stocks.

How to Do It/Where to Go

For retirees and preretirees who are convinced that it’s a good time to derisk, the question is how to do it.

First, what not to do: jettison stocks and go all-in on safety. Yes, uncertainty reigns over both the economy and markets. But the best way to confront uncertain times is with humility and a portfolio that’s diversified enough to perform reasonably well in a variety of scenarios. While recessions and sequence risk are a particularly big problem for portfolios that are too stock-heavy, inflation is the chief threat for portfolios that are too timid and bond-heavy. That’s because the return potential of an all-bond portfolio is relatively constrained, so inflation will tend to gobble up a bigger percentage of returns than is the case with balanced or more equity-heavy portfolios. The Bucket portfolios that I often write about include stocks for the good times, bonds for recessionary periods and flights to safety when stocks fall, and cash for when both stocks and bonds struggle, as they did in 2022.

How much you drop into each of those three buckets depends on your spending rate and your proximity to spending. In my standard three-bucket setup, I earmark one to two years’ worth of withdrawals for cash and another five to eight years’ worth of portfolio withdrawals in bonds. Spending from those two buckets could tide you through an extended equity-market downturn. You don’t want to start building out the cash position until you’re a few years from retirement, as the opportunity cost is too great.

How aggressively you go about derisking depends on how far your portfolio is from your target asset allocation and how close you are to retirement. If your portfolio’s current allocations are dramatically out of whack with your targets and you are already retired or expect to retire within the next few years, it’s wise to derisk as swiftly as practical. If retirement is further into the future and/or your current allocations are only modestly away from your targets, you could take a more gradual approach to enlarging your safety portfolio, dollar-cost averaging from stocks to bonds and/or steering new contributions to safer assets.

Finally, derisking has the potential to trigger a tax bill. You won’t owe any taxes if you focus your rebalancing activities on tax-sheltered accounts. But if you need to rebalance your taxable portfolio, it’s best to use new contributions to address the imbalance and/or get some tax advice on the implications of selling appreciated equity holdings.