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By Dale Roberts, for Boomer & Echo
Special to the Financial Independence Hub
Retirement can be a scary time for retirees who have considerable and even modest portfolios. We want to protect those assets. And certainly the risk tolerance level for most retirees will drop considerably. And that risk tolerance level will often drive the bus with respect to your allocation to bonds and cash and other risk management techniques you might put to work.
While the order of returns does not matter considerably in the accumulation stage, when we enter retirement we face that sequence-of-returns risk. Years of poor stock market returns early in the retirement funding stage can permanently impair your portfolio and your retirement. And in fact the risk to retirees begins well before that retirement start date. On Cut The Crap Investing I wrote on that with You Should Protect Your Retirement Portfolio Long Before Your Retirement Start Date. [This also ran subsequently here on the Hub.] Have a read of that article and you’ll see that the Retirement Risk Zone is typically qualified as 5 years before retirement and your first 5 years in retirement. We have to be careful as we approach retirement and in those first few years.
Can a near retiree almost completely de-risk the portfolio and sell a large percentage of their stocks? Sure, it may be emotionally pleasing, but with less stocks in hand it may slightly compromise late accumulation stage portfolio growth. That said, the most important part of it all might be that comfort level and that stress reduction event that comes with greatly lessening that stock component. And let’s face it, some near retirees who’ve planned well and who are lucky enough to have a generous defined pension plan might not need much or any inflation-beating portfolio growth. We’re all snowflakes when it comes to retirement funding, we are all entirely unique in our needs and our situation.
But let’s look at a scenario where a retiree does need their personal portfolio to work very hard; they are counting on that portfolio to deliver a generous component of their ongoing retirement funding needs. It’s time for those hard-earned monies to work for them. On the ‘rule of thumb’ spend rate for portfolios see my Boomer and Echo guest post: The 4% Rule: Is There A New Normal for Retirees?You’ll read that historically a retiree with a sensible mix of stocks and bonds can spend at the rate 4%-4.5% of the portfolio value each year, with an adjustment or increase each year to compensate for inflation.
Given that we want some growth in the later stages of accumulation and we need that growth component to potentially earn returns above that 5% range, we do not want to abandon that Balanced Portfolio model, we still need those stocks.
To manage the risks, we want to keep that nice mix of Canadian, US and perhaps International stocks to work in concert with that bond component. And the most conservative range that we might move to is 80% to 70% fixed income. That’s a very conservative mix of course.
The returns might be muted but you might be able to eek out 3% income from your fixed income component (a mix of bonds and GICs) and perhaps if stock markets continue to deliver 9-10% annual you must see a returns breakdown such as this:
- 70% of portfolio @ 3% = 2.1%
- 30% of portfolio @ 10% = 3%
That might give you a return in the 5% annual range if the stock market ‘rally’ continues and the bond market does not come under pressure.
Now it’s time to dollar cost average back into stocks
OK, so you’ve largely de-risked but you want and need your portfolio to work as hard as possible. When you hit that retirement date you can begin to increase your stock exposure over time. You might become a retiree stock ‘dollar cost averager’. Yup, you’ll employ the tried and true technique that many of us employ in the accumulation stage: you’re going to add to your stocks on a regular schedule.
You’ve de-risked and then you begin and continue to add risk. They call this an equity glide path. And this has been described and studied in detail by retirement funding rockstars Wade Pfau and Michael Kitces. Here’s their White Paper on the strategy. Continue Reading…
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Your handsome $350,000 RRSP portfolio gets clipped to fall below $200,000. If a retiree was spending down in typical fashion on the above portfolio they would have seen that $350,000 drop to the $170,000 range. If one entered retirement with an aggressive all-stock stance, they might have their retirement permanently impaired. The Retirement Risk Zone is more about the retirement funding math compared to your tolerance for risk.
The retiree has been adding monies on a regular schedule for 5 years and has a negative rate of return. The real rate of return when we factor in inflation is even less favourable. The retiree started 1998 with $350,000, added $42,000 and ended the period with just over $369,000.
And of course, to a point, the more conservative a portfolio (more bonds) the better for the test. But hey, that’s all certainly hindsight as we’ve picked the worst possible retirement start date. Right? Not so fast. Even if we look at the 2008 market correction protecting the assets well in advance works much better, and the more conservative the balanced portfolio, the better. You might at least keep your equity allocation in the 30%-40% area.
The only time this strategy will fail, that is deliver opportunity cost, is when we take out a severe market correction and invest only in a period of mostly rising markets (bull markets). Of course as an investor or advisor that is not a risk that you want to take. You do not want to guess that a stock market correction is not in the near future. Stock market corrections historically come along with regularity. We are currently in an abnormal period of an extended (mostly) bull market run.
