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Numerous studies have delved into the topic of whether rebalancing a portfolio--periodically trimming appreciated securities and plowing money into those that haven't performed as well--helps improve its risk/reward profile. Most of that research points to there being a clear benefit in risk reduction, but less so for returns enhancement. That's an intuitive conclusion. After all, the standard method of rebalancing--moving money from stocks to bonds and vice versa--will tend to scale back on stocks over time as they outperform bonds over longer time horizons. That reduces volatility but doesn't help on the returns front relative to a portfolio whose equity allocation drifts ever higher.
Yet, I'd argue that how much value you place on rebalancing depends completely on life stage. Most younger investors don't worry too much about controlling risk in their portfolios; generating returns is where it's at. For them, periodically reducing risk through rebalancing falls into the category of "nice to have," but it's not mission-critical. Making regular contributions and maintaining an equity-heavy mix through volatile market conditions will tend to be far more impactful. Indeed, many accumulators who took a hands-off approach to their portfolios might be inclined to stick with a similarly laissez-faire approach through retirement.
But the utility of rebalancing shoots up in retirement, in ways that I don't think are discussed enough among investment experts. Of course, rebalancing is beneficial from a risk-reduction standpoint, and risk reduction is arguably even more important in retirement than during accumulation. But rebalancing also brings multiple additional benefits. Cash flow sourcing is at the top of the list, as it's increasingly important in the current era of ultralow yields. Rebalancing can also help with diversification, taxes, and charitable giving.
Here's a closer look at the virtues of making rebalancing part of your retirement portfolio plan--as well as a bit of detail about how to do it.
Reason 1: It can help you source cash flows. Times are hard for retirees who were hoping to subsist on whatever income their portfolios kick off. One effect of the Federal Reserve's actions to head off an even worse economic disaster has been that yields on cash and other safe securities have dropped dramatically. The Bloomberg Barclays U.S. Aggregate Bond Index is currently yielding about 1.50%. Dividend yields on equities have held up better, but there have been dividend cuts there, too, especially in the financials, energy, retail, and leisure sectors. A 60% S&P 500/40% Aggregate Index portfolio is now yielding about 1.75%. That type of income stream simply isn't enough for most people to subsist on, except for retirees with pensions or very high levels of portfolio wealth.
That's partly why I think rebalancing can be so helpful in retirement, in that it broadens your horizons beyond current income. If your portfolio's yield comes up short in a given year, you can turn to rebalancing to help make up the difference. Of course, there will be years when appreciation and rebalancing opportunities are scant, and yields are also underwhelming. The year 2018 comes to mind, and 2020 may well be another. That's why I recommend that retirees also maintain cash reserves to help them salvage their cash flows and maintain their standard of living in those lean years. But in many other market environments, the combination of current income and rebalancing proceeds provides a terrific, well-diversified cash flow engine.
Reason 2: It can help you build a better-diversified portfolio that's not overly reliant on current income. In addition to helping to diversify your cash flows, a retirement portfolio strategy that encompasses rebalancing can help you build a better-diversified portfolio, period, versus one that focuses on yield-rich sectors alone. As we've seen in stark relief so far in 2020, many higher-yielding investment types are also economically sensitive. Because of that, and related dividend cuts resulting from tough business conditions, dividend payers have experienced a tough campaign so far this year. Even very good dividend-focused equity funds like Vanguard High Dividend Yield ETF VYM have lost about 10 percentage points more than the broad market so far in 2020. Meanwhile, yield-rich bond funds have struggled relative to high-quality bonds for similar reasons, as investors have questioned the ability of lower-quality borrowers to make good on their obligations.
At the same time, securities with underwhelming yields--notably technology stocks and Treasury bonds--have been pacing the market and could potentially be trimmed via rebalancing to help meet living expenses. That's not to say you should exclude yield-rich securities from your retirement portfolio altogether, but my bias would be to embed them alongside non-dividend-payers for a smoother overall ride.
Reason 3: It can help you manage your portfolio's risk levels and stick with your asset-allocation plan. That gets back to the big benefit of rebalancing regardless of life stage: It can help ensure that you maintain your portfolio's risk and allocation levels on an ongoing basis. That sort of volatility control is especially valuable to retirees, who have no choice but to draw upon their portfolios for living expenses no matter what the economic environment.
The recent market action provides a great example of how powerful rebalancing can be from that standpoint. Of course, few people saw this pandemic coming last year, along with its related economic and market dislocations. But coming off of 2019's monster equity-market rally, investors adhering to a disciplined rebalancing regimen would have been trimming stocks and using them for 2020 living expenses and/or adding them to bond holdings.
Reason 4: It can help you meet your tax obligations. I like the idea of retirees doing a single, once-annual checkup of their portfolios. At that time, they can check their portfolio's allocations relative to their targets and determine whether rebalancing is in order. And retirees who are age 72 and above and therefore subject to required minimum distributions from their tax-deferred accounts can also tie their RMD-taking into the rebalancing process. (Note that RMDs are suspended in most cases for 2020, but they're likely to be back in effect in 2021.)
Specifically, retirees can source their RMDs from those holdings they wanted to scale back on anyway. They can steer them into their taxable cash accounts for the year ahead, or if the RMDs exceed their cash flow needs, redeploy them into whichever assets need topping up in their taxable accounts. (They could even steer the rebalancing proceeds into a Roth IRA, provided they have enough earned income to cover the amount of the contribution.) In so doing, they'd fulfill their tax obligations while also improving their portfolios and/or sourcing cash flows.
Reason 5: It can assist with charitable giving. Relatedly, rebalancing can also serve as the source of funds for charitable giving, simultaneously satisfying a retiree's charitable goals and earning a tax break while also helping to improve the portfolio. If a retiree wants to make rebalancing-related adjustments to his or her taxable account, those appreciated positions can be donated directly to charity or to a donor-advised fund. That yields two benefits: It washes out the taxes due on the appreciation and potentially earns a tax deduction on the value of the contributed shares. Even though many fewer households are itemizing their deductions than in the past, the CARES Act passed in early 2020 made way for a $300 deduction for contributions of cash made to charity.
Alternatively, the qualified charitable deduction, or QCD, is also available in 2020, allowing investors who are age 70.5 or above to donate up to $100,000 from their IRAs to the charity(ies) of their choice. Of course, because RMDs aren't required for 2020, some investors might prefer to not touch their IRAs at all in 2020, especially if their balances are down. But the amount that the retiree steers to charity via a QCD isn't taxable, and it also reduces the size of the IRA balance overall. Moreover, the QCD can be tied in with rebalancing, with QCDs sourced from the very securities that the retiree wanted to scale back on anyway.