Transitioning from a steady paycheck to living off your life savings is one of the most significant, and potentially stressful, pivots you’ll ever make. There is a dizzying amount of conflicting “expert” advice out there, but for a lot of people, this just adds to the confusion. Between fluctuating market volatility and the nagging fear of outliving your nest egg, trying to pin down a sustainable retirement strategy can feel like trying to solve a jigsaw puzzle in a windstorm. You’re likely staring at your accounts and asking the ultimate question: Is my portfolio actually ready to support the life I’ve planned?
The answer to this question for your specific situation requires deep and careful analysis. However there are five general questions we at Facet commonly get from our members. Here are some thoughts on how we might answer each.
Should my portfolio get more conservative as I enter retirement?
The generic answer is yes. But the answer for you is a lot more complicated.
In retirement, downside protection does become more important. If you are forced to sell stocks during a down market to fund your living expenses, you wind up locking in some of those losses. A healthy allocation to stability assets, such as bonds or cash, could mitigate this risk. Those allocations are less likely to suffer large losses during a stock market sell-off. You could take some or all of your draws from this allocation, and avoid selling stocks during down periods.
However, you also need enough growth in your portfolio to make sure it lasts your lifetime. A portfolio with too large of a cash and bond allocation may not be enough to keep up with inflation much less also keep up with your portfolio draw rate. You may also want to have some money left over to leave to your heirs or give to charity. Those kinds of goals heighten further the need for growth in your portfolio.
Therefore you need to strike the right balance of growth and safety. Exactly what the right balance is for you depends on a lot of factors.
- What is your draw rate?
- How flexible are you with your spending?
- Will you have any other sources of income in retirement?
- Do you have special tax considerations?
- Is there an age gap between you and your partner?
- How important is legacy planning for you?
These and many other factors are why each retirement plan is unique. As a result, the question of post-retirement asset allocation is never a one-size fits all. This is why we don’t recommend target date funds, or using simple rules-of-thumb for asset allocation.
Is my portfolio diversified enough?
This is a major mistake we see with a lot of pre-retiree portfolios: portfolios that are too concentrated.
Here are three common diversification mistakes we often see.
- Too much single stock risk. Maybe you bought Apple or Nvidia years ago and have a huge gain. Or maybe the company you worked for gave you stock as part of your compensation. Now that one stock is an outsized risk in your portfolio.
- Heavy sector overweights. Often we see this become a problem in someone’s portfolio accidentally. A sector like tech that has outperformed the last decade just naturally becomes way too large inside the portfolio. Even within the S&P 500, the top 10 tech stocks have grown from about 20% of the total index a decade ago to about 40% today.
- Lack of geographic diversification. U.S.-based investors tend to have U.S.-heavy portfolios. It is common for us to see pre-retirees with almost no allocation to non-U.S. stocks.
Here is the potential danger with all of these concentrations: they all increase your portfolio’s volatility. As we said above, when you are in retirement, downside risk protection becomes more important. These overly concentrated portfolios could result in more frequent and/or deeper declines in your portfolio’s market value. This in turn increases the risk that your portfolio draws could lock in losses.
When you are still building your portfolio, you have time to wait out volatility. When you are in retirement, you risk this “loss lock-in” effect impairing your portfolio’s ability to rebound in the future.
As it pertains to single stocks, there is always the risk that a single company declines significantly in value. But there is also the risk that the stock just moves sideways for extended periods. If you are drawing down your portfolio, this alone creates a major risk. Over the last decade, only 14% of stocks within the S&P 500 outperformed the whole index. Betting on a single company is like rolling a die that is loaded against you.
Second, a lot of times investors get hung up on the tax consequences of selling their concentrated positions. Don’t let the tax tail wag the portfolio dog. The only way to avoid taxes is to never use the money (or to lose all of your gains!). If someday you are going to spend your money, then someday you are going to pay taxes. If you have acute risks in your portfolio, it is usually better to deal with those sooner than later, even if it means paying some tax.
Am I producing enough investment income to fund my retirement withdrawals?
Retirees sometimes get too focused on separating income from other kinds of investment returns. Here we’re talking specifically about dividends from stocks. Putting too much weight on income could lead to serious investment mistakes.
There is a certain profile to companies that pay out higher dividends than others. Take the top 100 highest dividend paying companies in the S&P 500. Compared to the rest of the index, they have:
- A higher debt load: On average, debt totals 40% of the net worth of the high dividend companies, vs. just 13% for the other 400 stocks.
- Slower revenue growth: Last year sales grew just 6% for the high dividend companies, vs. 17% for the rest of the S&P 500.
Companies with a lot of growth prospects tend to reinvest profits back into the company. Companies without a lot of growth opportunities may instead pay out profits to shareholders. Moreover, these same slow growing companies are often the ones taking on debt to do mergers or other maneuvers to manufacture growth.
Sometimes investors assume that high dividend companies are safer than the average company, but this is not necessarily true. Some of the highest dividend paying sectors are also the most volatile, such as real estate and energy. Certainly companies with high debt burdens tend to be riskier than those with stronger balance sheets. Using high dividend rates as a stand-in for safety could lead to serious investment mistakes.
There are many other “passive income” traps that retirees could fall into, for example:
- Real estate
- Master Limited Partnerships (MLPs)
- Options-based income strategies
Wall Street knows that a lot of investors get too focused on income, and are happy to supply high-fee products to satisfy that demand. We believe it is better to target an overall portfolio risk and return profile that fits your needs in retirement, and worry less about how much of that return is coming from capital gains vs. dividend payments.
How do I protect against inflation?
Inflation is a pernicious problem for retirees. If your cost of living rises in retirement, there’s no guarantee your investment returns keep up. In fact, it might be the opposite. As we saw in 2022, inflation spikes tend to cause both stocks and bonds to decline in value.
There is no one magic solution to protecting yourself against inflation. However, there are some steps you could take to mitigate its effects.
- Include inflation in your plan: Instead of assuming some flat withdrawal amount, assume your draws grow by some relatively high inflation rate. Test to see if your plan is especially vulnerable to higher inflation.
- Have enough growth in your portfolio: A portfolio with a higher growth rate provides some natural protection against inflation, as this could allow you to grow your withdrawal amount over time.
- Add additional diversification: Bonds have historically done a great job protecting portfolios in recessionary environments, but tend to suffer during high inflationary periods. Consider adding alternatives that are well-suited to protect against inflation.
- Beware inflation protection traps: Some strategies sold as inflation protection work better than others. Especially watch out for highly volatile assets, like gold or commodities. If they add to overall portfolio volatility, they could do more harm than good for retirees.
How do I know how much I can afford to withdraw in retirement?
This is by far the biggest question we hear from Facet members. Unfortunately there is no simple answer. One popular rule-of-thumb is called the 4% rule. This is where you based your annual draw rate on 4% of your portfolio value at the time of your retirement. For example, if you retire with $2 million, you would start drawing $80,000 per year. You then keep drawing that amount, typically adjusted for inflation, through up and down markets.
This isn’t a bad starting point for thinking about retirement, but a real-life plan is almost always much more complicated than the 4% rule implies. Such a plan doesn’t take into account a myriad of issues:
- When will Social Security kick in? What about pension income or insurance policies?
- Larger one-off expenses, such as a big trip or paying for education
- Handling tax issues, especially related to required distributions from your IRA or 401k
- Timing of retirement - 4% might be aggressive for someone retiring younger, while someone retiring older might be able to draw more
- Legacy goals: do you want to leave money for the next generation, or are you willing to risk drawing down your portfolio value?
- How flexible can you be with your spending? You may be able to afford to take a larger percentage initially if you are able to cut back during down markets.
These are just some examples of many reasons why your plan is probably too complicated for a simple rule-of-thumb. The idea behind the 4% rule was based on investment volatility, which is certainly a big factor in retirement planning. However, it is hardly the only factor. In order to build a sustainable retirement plan, it should be tailored to your specific situation.
