Asset allocation is a concept that most investors adhere to in theory, but in practice have not implemented. Unfortunately, investors who have diligently saved and invested for decades may undermine their diligence by neglecting asset allocation in retirement. As investors transition from contributing to a portfolio to withdrawing from it, asset allocation becomes even more important. It is one of the factors contributing to whether a retiree will have adequate cash flow when they are no longer working. Here we cover asset allocation basics, and questions retirees may want to ask to ensure that the asset allocation meets their needs.
Asset allocation basics
Asset allocation means dividing an investment portfolio amongst different asset classes. It helps investors balance risk and reward by investing in different assets that don’t move in the same direction at the same time. All investors want their portfolio to move up, but no asset class moves up in a straight line. Allocating money among different types of assets tends to reduce portfolio volatility and may increase returns in some cases.
At a basic level, investors typically want to have a set ratio of stocks, bonds, and cash within their portfolio. Of course, investors may want to get a bit fancier and include more granular asset classes, such as small-cap or emerging market equities and different gradations of bonds.
Regardless of the specificity of the asset classes being considered, asset allocation is widely considered to be one of the most important considerations in portfolio construction. One academic study showed that more than 90% of returns in a portfolio were driven by asset allocation. And appropriate asset allocation can help maximize “risk-adjusted returns” or the portfolio’s returns adjusted for volatility. In other words, appropriate asset allocation can help investors have a more efficient portfolio.
While asset allocation matters for most investors, not every investor has an asset allocation strategy. Those that do have a strategy, may not think to adjust it over time. However, most retirees and soon-to-be retirees could benefit from re-evaluating their asset allocation during retirement.
Asset allocation during retirement vs. accumulation
During an investor’s working career, that investor is likely focused on saving and investing enough for retirement. A common investment goal is for the investment to do as much of the “heavy-lifting” of wealth accumulation as possible.
But all of that saving and investing is done with a future state in mind. In time, the working investor typically wants to become a retired investor. These retirees typically want to spend their money on things and experiences that bring value to them without worrying too much about their investment portfolio.
With the shift from accumulation to spending, most retirees (and soon-to-be retirees) may want to reevaluate their asset allocation strategy.
Do you have an asset allocation plan that is suitable for retirement?
If you’re a retiree or a soon-to-be retiree, it makes sense to revisit your asset allocation plan. Asking questions about your investment strategy can help you clarify a suitable retirement asset allocation for you. These are a few questions to consider as you transition to retirement.
Have you evaluated your investment goals?
In most cases, working investors care more about investment returns and retirees care more about cash flow and funding their lifestyle. However, not every investor switches their asset allocation when their goal changes.
Around five to ten years before retirement, working investors may want to re-evaluate their investment goals to ensure it matches their current desires. By the time an investor transitions to retirement, it is likely that the investor’s goal has changed. In most cases, retirees care much more about having cash flow to cover spending as opposed to gaining the highest returns.
If your investment goal has changed, your asset allocation may need to change with it. This is something that most investors should consider during the decade before retirement.
Why did you pick your asset allocation?
If you have an intentional asset allocation strategy today, consider why you chose it. If your circumstances and goals have changed, you may want to reconsider them.
What is the methodology for selecting your asset allocation strategy?
Asset allocation strategies are typically designed for either accumulation or withdrawal from a portfolio. If you’re closer to taking distributions from your portfolio, you may want to ensure that your asset allocation strategy works for that distribution plan.
Have you considered your spending and income during retirement?
As you consider retirement investment goals, it is important to keep in mind both your income and your spending during retirement. Some investors may be able to cover their lifestyle with pension and Social Security income. Other investors may need to fund all their lifestyle expenses using withdrawals from their portfolios. Each of these investors may want to approach asset allocation differently, given their different circumstances.
The Retirement Budget Calculator equips users to understand their circumstances, by considering spending, expected inflation rates, and expected income over time. These numbers may influence investor’s ideal asset allocation.
Will you rebalance your portfolio in retirement?
Different investment distribution strategies call for different rebalancing strategies. Some are complex and could require help from a financial advisor. Consider whether rebalancing makes sense for you. If it does, make sure you feel capable to rebalance on your own or work with a fiduciary financial advisor to ensure the portfolio will be rebalanced following your strategy.
Have you considered your new investment time horizon(s)?
It’s no secret that the Retirement Budget Calculator promotes the “bucket” investment strategy. This strategy helps investors diversify their assets across periods. Once the assets are divided among short, medium, and long-term portfolios, each portfolio is assigned an asset allocation based on time and volatility considerations.
Whether investors adopt a bucket approach to investing is up to them. However, all investors in retirement should consider their investment time horizons in retirement. New retirees typically have expected lifespans of more than 20 years from the date of their retirement. So most retirees need to consider long-run returns, but they also need to consider their current cash needs.
When should you take action regarding your asset allocation?
Investment strategies and especially distribution strategies require discipline, and investors can suffer if they take action too often. However, investors must remain nimble even during retirement. If you’re not sure when to take action regarding your asset allocation, you may not have a clear enough strategy. Rather than hoping everything will be all right, consider working with a trusted financial advisor, or doing more research to ensure your asset allocation makes sense.
Are there consequences if you don’t act?
Most retirees want to ensure that their income or cash flow matches up with their expenses. As long as the asset allocation is adequate to allow that to happen, the investor may be happy with the allocation. But if the allocation is too aggressive (leading to crashes at the wrong time) or too conservative (such that money starts to run out), the investor may see lifestyle implications to not acting.
Asset allocation is one key to creating a cash flow strategy that works in retirement. But the cash flow strategy that worked during the wealth accumulation years may not work for a retiree. Retirees should take some time to re-evaluate their asset allocation, and make sure that it fits with their distribution strategy.