Ep #8: Retirement Risk #3: The Risk of Being Too Conservative
In the previous two episodes, we have covered the sequence of return risk (which talks about why having a retirement projection is not really a plan), as well as longevity risk (which is the ability to accurately save for the length of the rest of your life). Today we’re talking about the risk of being too conservative, also sometimes referred to as asset allocation risk, and how to allocate your assets in a way that will allow you to have a successful retirement.
Listen in as I explain the importance of diversifying your investments to ensure income flow throughout your retirement, as well as how to protect your investments. You will learn how to optimize your portfolio returns, the benefit of getting into investing when you’re younger, and how to decrease your risk as you head into retirement.
Contents hide
1 What You’ll Learn In Today’s Episode:
3 Resources In Today’s Episode:
4 If you like Your Retirement Planning Simplified…
5 Retirement Risk 3: Risk of Being too Conservative
7 Creating a Lasting Investment Portfolio
8 A Brief History of Allocations in Retirement
12 Balancing Between the Two Buckets
14 The Risk of Being too Conservative
17 Whenever you’re ready… here are 2 ways I can help you with your Retirement Planning:
What You’ll Learn In Today’s Episode:
What asset allocation risk is.
How to ensure a successful retirement.
How to keep ahead of inflation.
What “offense” and “defense” buckets are and how to use them.
How to optimize your portfolio returns.
The importance of taking fewer financial risks as you enter retirement.
Ideas Worth Sharing:
“Make sure you’re allocating your assets in a way that will help you be successful in retirement.” – Joe Curry
“We want to have a combination of different types of investments.” – Joe Curry
“The older we get, the less risk we want to take.” – Joe Curry
Resources In Today’s Episode:
If you like Your Retirement Planning Simplified…
Never miss an episode by subscribing via Apple podcast, Spotify, Stitcher, Google podcast, or by RSS!
Retirement Risk 3: Risk of Being too Conservative
We’re excited to continue with our retirement risk series, specifically, Retirement Risk # 3: the risk of being too conservative, also sometimes referred to as asset allocation risk.
What is Asset Allocation?
To clarify, asset allocation is how you’ve allocated your different investments. If you consider a pool of investments, examples of some different asset classes might be stocks or bonds, cash, or real estate. When we’re discussing the risk of being too conservative, we want to make sure we’re allocating your assets in a way that will help you to enjoy a successful retirement. Some of the common advice around retirees and how they should allocate their investment portfolios is to have guaranteed type investments or low-risk investments income paying stocks or bonds or securities, but this advice is not necessarily helpful in terms of longevity for your portfolio.
Creating a Lasting Investment Portfolio
We have many clients who look at stocks as a growth type of asset. They feel that in the long run stocks will work out, but they also might feel that they don’t have a long time horizon to achieve this. For example, you may plan on retiring now or even in a couple of years. The first thing we would say is that if you’re just retiring today and you’re 60, or 65 years old you need to remember longevity risk. In retirement, you could easily have 30, 40, or even 50 years after retirement. The idea is that you need a bit of your portfolio in the short term to generate income but most of it is going to be invested for a longer period going forward. You want your portfolio to work for you to ensure that it carries you through the remaining years.
A Brief History of Allocations in Retirement
It’s helpful to give a brief history lesson on allocations in retirement. If we go back 50 to 60 years ago, bonds were the go-to investment for retirement. You would get your bond certificate, and clip off the coupon, which would be your interest, and that would be your retirement income for the month or the year. It was set up for you depending on the bond. And that was okay during a low inflationary period and shorter life expectancies in the ‘40s, ‘50s, and ‘60s compared to today. Then, in the ‘70s, we saw hyperinflation and some tough times for keeping up with the cost of living.
In the early ‘70s, we got through a bear market. From then onward, to keep ahead of inflation, people started investing more in dividend-paying stocks, and through the ’70s, and especially through the ‘80s and the ‘90s, there were a lot of large bull markets, meaning stocks did well. Those dividends compounded and it was hard not to use that strategy of having those dividend-paying stocks. However, with the .com crash and 9/11, as well as the global financial crisis of 2008, it became obvious that we not only need to think about growing our portfolios, but we also need to consider how to protect them as well. 2008 brought the focus back to safer investments and that we can’t be invested too aggressively heading into our retirement because we might lose everything in the next financial crisis.
Realistically though, we want to have a combination of different types of investments that are going to help you ensure you’re able to create income, even if stock markets are down. For example, we want to make sure you have some of your portfolio invested in a way that’s going to continue to grow and outpace inflation. This will support a long time horizon in retirement.
The Investment Buckets
The simplest way to look at this is if you think about your investments as buckets. If we use this framework, we can separate your investments into two specific buckets: defense and offense.
The Defense Bucket
Your defense bucket is going to be relatively low-risk investments, potentially some cash, as well as some no-risk investments as well. When considering a long time horizon, that’s the piece that we want to protect. It’s also the piece where you’re going to get your income despite what’s going on with more risky types of investments.
If we look at 2008, the global financial crisis, stocks crashed but they eventually did come back. It took roughly five years depending on what market we’re looking at for stocks to recover back to their previous levels. When we’re looking at protecting capital or protecting your investments to create income, we want to make sure that we’re protecting enough of your portfolio, that you can take income or withdrawals from your portfolio without having to sell a riskier asset when it’s down. History has shown us that markets work and if businesses can continue to innovate and come up with better ideas or better ways of doing things, in general, the economy and the stock market will grow. However, we don’t know short-term what’s going to happen, so we want to have a defense bucket set aside for safer investments.
For example, depending on your risk tolerance, you might have a year’s worth of income, or maybe a little less or more in cash. No matter what happens in any other investment, you know that you can get your hands on cash to buy groceries or pay for gas, heat, or hydro. And then the rest of that defense bucket could be made up of something like low-risk bonds, as an example. At the minimum, what we’re probably looking to do here is between that cash and those bonds is figure out what you’re taking out of your portfolio over the next five years, and make sure we have at least five years of income protected in those lower risk investments. This is the importance of your defense bucket.
If there’s something like stocks in your growth (offense) bucket, and the stocks are down, it gives you five years in that scenario, but it could be more. You can have more than five years, but that’s just an example that you could take income out of that defense bucket for five years, without ever being forced to touch your offense bucket, giving you time to recover before you need to touch it. Your defense bucket can also be an income bucket because that’s where you take your withdrawals from.
The Offense Bucket
If we knew exactly what our lifespan and inflation would be, we would know exactly how much we need to put in our overall buckets of investments. But unfortunately, we don’t know that, and this necessitates that we support growth. The offense bucket, or growth bucket, can have several different types of investments. A diversified portfolio of global stocks is ideal which means that you own many different companies across many different geographic regions to try to limit risk wherever possible. This helps you to participate in the growth of all the largest companies around the world. It’s also going to keep your money working for you for as long as you’re in retirement.
Balancing Between the Two Buckets
There are a couple of ways to figure out how much you want to have in your defense bucket and how much you want to have in your offense bucket. As you’re taking retirement income, you can take it out of your defense bucket so that you’re never forced to take losses on your growth bucket, and then each year we look at replenishing the defense bucket. If we want to have a certain amount of money in cash in years where stocks have done well, those would be years where we would also replenish the defense bucket, starting with replenishing the cash from your stocks or your growth bucket, with whatever assets that you have in there. The flip side of that is when stocks in your offense bucket aren’t not doing well but you don’t want to sell low, you can just continue to take your income out of your defense bucket.
Rebalancing
Another strategy is to move from bonds to cash. But, again, we won’t have to touch your offense bucket. It’s important to add a caveat here that will help with a quicker recovery. If we were to see another crash like 2008 and your offense bucket has stocks and your defense bucket has cash and bonds, when the market crashes, we would do what we call a rebalance. A rebalance is where we get you back to the optimal percentages in your defense and offense bucket. We could take some from your defense bucket and put it into your offense bucket.
Rebalancing gets you back to the optimal proportions of offense bucket and defense bucket and you’re also buying more units. So, if it’s stocks in your offense bucket, you’re buying more units or shares of stocks while they’re priced low so that when the market does recover, you’re getting more growth than you would’ve if you just let your stocks sit and recover at their own pace. Rebalancing is an important part of optimizing your portfolio returns. And again, it helps you make sure you’re maximizing your retirement investments to make sure you don’t outlive them.
The Risk of Being too Conservative
Returning to the risk of being too conservative, it comes from having too much allocated to the defense bucket or worse, having everything allocated to that defense bucket. The problem is if we have too much in that defense bucket you won’t grow enough to outpace inflation and provide income. What’s happening is simultaneously you’ll lose purchase power as the cost-of-living rises.
If all your investments are conservative, and the cost of living increases quicker than the return that you’re getting on your investments, you’re losing purchasing power, which is the same as having your portfolio decrease.
For most investors, in fact almost all the clients we talk to, the amount of money that they have saved in their portfolio is correlated to what they’re going to need in retirement. You will always need some growth in your investment portfolio. You can’t just sit on a pile of cash and withdraw as needed.
The Glide Path
What the research shows us is that we have a higher success rate with larger portfolios by decreasing risk heading into retirement and starting to increase it again, once we get into retirement.
It’s important to consider the rising equity glide path for asset allocation in retirement. The older we get, the less risk we want to take, but the rising equity glide path is a strategy that is very counterintuitive. However, it makes more sense when looking at the data. There’s a risk zone in roughly the five years leading up to retirement, which is retirement date risk. Meaning that if a big crash happens within five years of retirement, you may have to push back your retirement date for the portfolio to recover so that you have enough money to meet all your goals in retirement. And then after retiring within the first five to ten years, it transforms into the sequence of returns risk.
What the rising equity glide path talks about is, that as you get to within five years of retirement, it’s reducing your stocks at that point and increasing your bonds. Michael Kitces refers to it as a bond tent. As you approach retirement, you should increase your bonds. With the defense bucket, we’re starting to increase the number of bonds about five years ahead of retirement. And then once we get into retirement, we keep that higher allocation to your defense bucket or your bonds. Then through the first five to 10 years of retirement, we start reducing the bonds again. We start increasing the size of your offense bucket once we get back up to a much higher allocation to equities.
If you can mitigate the risks through that period leading up to retirement and early on into retirement, at that point if markets are bad, but you were conservative enough that you made it through, chances are that even if the markets have been bad, they’ll probably be good going forward, or good for a period.
If you start to increase your equity allocation and increase your offense bucket allocation, then you’re going to be ready for those higher returns. The flip side of that is if we get high returns in stocks in your offense bucket early into retirement, even though you’re more conservative, you’ve probably still built up enough that you’re in a good position moving forward to get back to the normalized long term portfolio we want to have set up.
Be Safe but not too Safe
To summarize, the risk of being too conservative or asset allocation risk is that safe assets like bonds, GICs, or cash, are traditionally viewed as ideal for retirees, especially since 2008, when people were worried about the next global financial crisis. The only guarantee if you have all those types of investments in your portfolio, is that you’re going to spend down your nest egg and lose your purchasing power, eventually running out of money in most cases. Most people need to have a portion of their portfolio growing continuously to ensure they don’t outlive their money.
Whenever you’re ready… here are 2 ways I can help you with your Retirement Planning:
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