Cal and Bridget were taken aback when a recent visit to a financial advisor produced a startling revelation: During their first five years of retirement, the return on their retirement assets had been outpaced by inflation. Now it became clear to them why their retirement nest egg seemed to be shrinking at an ever-increasing rate.
Like many investors, Cal and Bridget had largely pulled their retirement assets out of equities in a panicked response to the stock market's near-meltdown in 2008, shifting assets into fixed-income investments and cash equivalents instead. The story of Cal and Bridget illustrates an all-too-common tendency among many investors, particularly near-retirees and retirees, to be overly cautious in their retirement investing.
When you invest your nest egg too heavily in medium-risk, medium-return fixed-income investments or low-risk, low-return cash equivalents, you reduce market risk, but you also expose your portfolio to too much inflation risk. Although fixed-income investments can play an important role in any retirement portfolio, growth-oriented investments, which can include stock funds and real estate accounts, can also be key players. Your asset allocation should reflect the fact that, thanks to medical advances and increasing life expectancies, retirement today lasts a lot longer than for previous generations. A person who retires at 65 is expected to live nearly 20 years in retirement, on average1.
By keeping a portion of your portfolio in growth investments, you may be more likely to achieve a long-term return that exceeds the inflation rate. This is important, because you want to be able to deal with rising costs, including healthcare costs, over the years. Growth-oriented investing may also help you build wealth to leave behind to your heirs. However, growth investments also carry a risk of loss.
The asset allocation (investment mix) you create for your retirement portfolio is now, and will always be, the single biggest factor behind the results achieved by the portfolio. Your retirement assets should always be divvied up among the various asset classes in accordance with your goals, how much time you have available to achieve those goals, your objectives for return, and your tolerance for risk.
It's true that when you're getting close to retirement, it can make sense to start shifting some of your portfolio out of growth-oriented investments and into fixed-income investments like bonds, bond funds and fixed annuities. Growth investments seek to emphasize increases in the value of the investment, while fixed-income investments are all about producing income. Research suggests you will need between 40%-50% of your preretirement income to serve as a retirement income "floor" just to cover basic needs like food, shelter, clothing and healthcare. When you have an established income floor, you're less likely to have to sell growth-oriented investments to make ends meet, which can be especially painful if you sell in a slumping market. Some planks in your floor might be provided by Social Security and other income sources, possibly including a private pension. To increase the chances that you'll be able to meet basic needs the rest of your life, you may want to consider securing a guaranteed stream of income by investing in a fixed life annuity2.
Cal and Bridget, like many people, responded to a freefalling stock market by becoming overly cautious in their retirement investing. By the same token, when the stock market heads into the stratosphere, you should avoid reacting euphorically by moving all or nearly all your assets into equities. You might end up buying investments when they're at peak value, and you could put your portfolio at too much risk.
Stay focused on keeping your asset allocation aligned with your goals, time horizon, return objectives and tolerance for risk. Diversification is also key: make sure your assets are spread among a sufficient number and variety of investments, so that you could be better able to absorb losses on any one investment.
The asset allocation you create for a portfolio from which you’ll make withdrawals should probably differ a great deal from one you don’t plan to touch. The reason: you can take on more risk in the fluctuation of the value of an untouched, accumulation-focused portfolio. For example, if you're a highly risk-tolerant individual investing for the long term (30+ years), and you have no chance of needing to withdraw during that time, a very aggressive portfolio with significant exposure to equities could be appropriate for you.
However, few investors are able to invest over a very long time horizon without needing to withdraw for spending needs in retirement. As you move to a stage in which you're both investing and withdrawing funds from an account, the way the account is managed needs to change. Investment programs that include withdrawals not only must seek to generate returns, but also, the consistency and volatility of the returns must be closely watched. If you start withdrawing funds during an extended period of poor returns, your investment program could be permanently damaged. A trusted, professional financial advisor can help you create a highly personalized investment and withdrawal strategy.
Take a fresh look at your retirement asset allocation at least once a year, or more often in the event of a major life change that could affect your financial picture. For example, if your health changes, you go through a separation or divorce, or you lose your spouse or partner, you might need to adjust your asset allocation.
You may well benefit from enlisting a professional financial advisor to provide guidance on retirement investing. The right advisor can use his or her knowledge and background to help you maintain an appropriate asset allocation from this point on and navigate the broader range of issues you need to address as you plan for your long-term financial well-being.
1 Centers for Disease Control life expectancy statistics: http://www.cdc.gov/nchs/data/hus/hus11.pdf#022
2 Guarantees are subject to the issuing company's claims-paying ability.
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