In part three of this series, we discussed how to create a low-cost portfolio invested in the global economy that reliably returns market returns, less costs, year in and year out while diversifying away the risk of picking and owning stock in individual companies.
We discussed how to set up two indexed sub-portfolio one for bonds and one for stocks, that can be increased or decreased relative to each other without changing the relative allocation of the different kinds of sub-asset classes in each—US, Europe, Asia, emerging markets, small-cap, and value for stocks, short and intermediate term Treasuries, corporate credit, high-yield, inflation-adjusted and international for bonds.
Using low-cost index funds and low cost custodians, we also discussed how the cost of holding and rebalancing such a portfolio can be lowered to a fraction of the cost charged by the big banks and fund companies. Indexing also ends the need to guess what stocks or funds are hot, concerns about their past performance, and guessing how they will perform in the future. These concerns can be put out of your mind. and you can focus on your life, not the stock market.
That leaves only the issue of how much to allocate to risky assets—stock—and how much to allocate to safer assets like bonds and cash. Varying the size of the stock sub-portfolio relative to the bond sub-portfolio and to cash controls how much market risk—and possible losses—your investments may have to ride out. And how much risk you are taking with your retirement income stream.
For those in the red zone, age 55-65—and now perhaps extending from age 50-70 (I’ll be covering red zone topics in my next series of posts)—few things are more important to your investment strategy and the success of your retirement plan than ensuring you are not overexposed to market risk just when you begin to need your life’s savings and investments for retirement income.
How Much Risk Should You Take?
How much should you allocate between stocks, bonds, and cash? How do you set the stock/bond/cash allocation? How do you know if you are over- or under-exposed to market risk?
There are almost as many answers to these questions as there are financial advisors! But only one that answers the question based on your specific household financial situation.
Some use rules of the thumb, like ‘age in bonds,’ an old chestnut that arbitrarily reduces exposure to stocks as you age. This has been contradicted recently with an approach that is more risk-off early-on when entering the red zone, that then allows the stock allocation and risk exposure to rise, as may naturally happen as stocks grow faster than bonds over the 30-year retirement period.
Then there are target-date retirement funds that also reduce stock allocation over time as retirement nears, popular in 401(k) plans. These funds can be costly, and they vary sometimes considerably by fund company. Each has its own idea about how much risk you should have in the red zone and in retirement. The mix of funds, almost always the fund company’s own proprietary funds, also varies and may not be optimal. A target-date fund made up of expensive actively managed funds may expose you to more risk than makes sense for your situation while at the same time under-performing compared to indexed market returns!
Investment managers also have varying theories about portfolio ‘balance,’ depending on the investment products they offer and their assessment of something they call your risk tolerance. Others suggest the idea of risk tolerance varies over time and depends too much upon your perception of the state of the market, and should not be used to manage your risk exposure—the market has no such perception, and will do what it will do no matter how you feel about it. Still other investment managers are loathe to suggest you allocate anything to cash, characterizing it as dead money that loses ground against inflation, never mind that we are still teetering on the edge of deflation or that your personal situation suggests you should have some liquid funds.
At the end of the day, all of these approaches can be quite arbitrary and fail to address the most important factor for determining how much risk you should take, and which differs for each and every household: The strength of your household balance sheet and how well you are funded to support your retirement.
Two households of the same age may have a similar amount of savings and investments but differing Social Security and pension benefits and vastly different lifestyles (ie, annual expenses, otherwise known as recurring liabilities). Just because their financial capital is similar in size does not mean they should be invested in a similar way, with a similar stock and bond allocation and similar exposure to market risk.
One may have a weak balance sheet and can ill afford a 10% or 20% market drawdown, while the other may be so well-funded, there’s little need to take market risk—that household has already won the game and should perhaps be playing a ‘prevent defense’ in the market, with bond ladders or some other risk-free strategy.
Balance Sheet, Income Floor, and Cushion
Let’s look at some examples to see how this works. The Smiths, both about age 60, project they will have about $1,000,000 in savings and investments in various accounts when they plan to retire at age 65. They estimate that after subtracting Social Security and pensions of about $65,000/year, they will need $50,000/year, including taxes, to support their lifestyle as they enter retirement, netting out expenses that go away like FICA taxes and commuting, but adding in additional recreation and travel expenses. They are of average health, so their plan length is estimated to be 30 years.
They appear to be comfortably set, and want to invest more aggressively in the stock market to hedge future inflation, which concerns them.
So we prepare a household balance sheet that compares the present value of their assets and liabilities*. On the balance sheet, the present value of their Social Security is about $1,800,000 (now you know why it is important to carefully plan your SS claiming strategy—your SS benefit income stream may be among your most valuable assets!), which along with the $1,000,000 in savings and investments, gives them about $2,800,000 to offset all of the expenses they will have during their 30 years of retirement.
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The bad news is that the present value of their annual expenses is about $2,700,000, and with a $60,000 emergency fund (for 30 years!), they have barely $40,000 as a cushion to last through thick and thin. The present value “cost” of the $50,000/year they anticipate needing above and beyond SS/pensions is about $960,000. This is called their income floor.
To last throughout their retirement, their income floor should be set up as risk-free as possible, and so should not be exposed to market risk. Only the amount above the floor, the cushion should be invested in risky assets (stocks) and exposed to market risk. In this case, with such a small cushion, even that is probably not a good idea.
Based on the household balance sheet, we use the income floor to set the portfolio allocation. In this case, the Smith’s allocation would be about 96% bonds/4% stocks (960,000/1,000,000=96%). With such a small cushion, even bond funds are probably too risky for the Smiths, who should look at laddering CDs and individual bonds to lock in their income floor.
When the Smiths realized how constrained their situation actually was, they took another look at their plan. They decided to work three more years and build their savings to $1,250,000, which also reduces their plan length to 27 years. They also found some ways to reduce their anticipated expenses from $50,000/year above SS and pensions, to $40,000. Now their balance sheet looks like this:
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By delaying three years, the Smiths will add $250,000 of new savings and modest growth to their portfolio and by cutting expenses, they will add another $250,000 to their cushion, for a total new cushion of $530,000, and a new lower income floor of $720,000.
The new lower floor and increased portfolio means that their investment allocation can be 58% bonds/ 42% stocks (round it to 60%/40%)—which provides more flexibility in how they can invest the floor (bonds) and the upside (the risky stock allocation). Their retirement income plan is no longer constrained, and they are feeling much better about the life—beyond finances and balance sheets!—that they are planning for their retirement.
Using their balance sheet to determine how to allocate between secure and risky assets and how much to invest takes guesswork and market risk as a threat to their income floor off the table. They aren’t stuck in a one-size fits all fund that could be a mismatch for them, and they aren’t constantly worrying if their investment advisor is wrong about his market “projections,” no matter how many analysts he says are working back at headquarters.
Even more importantly, by taking a hard look at their household balance sheet, they gained an understanding that the rules of the thumb they had been using didn’t work so well for their circumstances and that they needed to make adjustments in order to create a solid retirement income plan.
Now the Smith’s understand their income floor and their cushion, and can decide how much of their cushion they are comfortable investing for the upside, while considering various ways to make their income floor secure for their life in retirement. They have a much better understanding of the relationship between their annual spending and the savings and investments they have to sustain it.
In short, they have a plan, and they can live by it.
Next time, we’ll start talking about the red zone and how it changes everything. In the meantime, if you have any questions or comments, please let me know!
–Mike Lonier, RMA℠
Note: *The examples above are intended to illustrate the way that a household balance sheet can be used in creating a household retirement plan, and are not intended themselves to be a personalized plan or projection for retirement income for any specific individuals. Financial planning requires the analysis of individual circumstances and personal goals. Present value analysis is a long-range planning tool that requires the use of future estimates of various discount and interest rates, and rates of return to estimate the time value of money. While these calculations may be mathematically sound and commonly used in time value of money calculations, markets are unpredictable and future projections are necessarily uncertain and cannot be guaranteed.