One of the most difficult things to do in the finance world is to manage a portfolio for retirement. When you’re young and growing a portfolio, there are a lot of things you can do wrong and still end up in pretty good shape. You have years to recover and time can heal some pretty big wounds.
Retirement is different. Here you are actually using the money for your expenses and you really don’t have much time to recover when things go wrong. You also might not be able to find a job and work should things go really wrong. In this article we’ll look at managing a portfolio in retirement and some of the things to consider and risks to be prepared against.
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The Risks with Retirement Portfolio Management
Investing in retirement has all of the standard risks of investing but with the added issues of needing to generate money from the portfolio and the lack of recovery time. The need to generate income means that you’ll need to either have assets that generate cashflow or you’ll need to sell assets as you go to create cash. (There is a third option we’ll also get into, but in a way this is just selling assets as well.) The risks you face are:
- Losses due to declines in asset prices. Because you’ll need to sell assets regularly, you will not necessarily be able to wait until prices recover before you sell.
- Money lost to taxes. This can usually be planned for and minimized, but tax laws can change.
- Large, unexpected bills. Medical bills are the most likely item, but it could also be nursing home bills or the need to help a family member.
Losing money because assets decline is always a possibility when investing. When you are young, you reduce this risk by
1. diversifying your investments, spreading it out to many different stocks, bonds, real estate, and maybe other asset types and
2. investing for long periods of time, letting the random market fluctuations wash out and taking advantage of the natural tendency of assets to increase in value with the economy in general.
When you’re in retirement and using your portfolio, you lose some of your ability to wait and invest long-term. You need that $1000 for groceries or $1500 for the mortgage each month even when the market declines.
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Losing money due to taxes is another risk. In some cases, taxes are predictable and therefore you can plan on them and adjust how you save and invest, as well as how you withdraw money, to minimize them. But taxes are also changeable and who is in government now and in the future can have a dramatic effect on how much you pay in taxes. This could be a direct tax on the money you have saved up such as a wealth tax or taxing income from accounts that were tax-free when you started them. It can also be things like increases in sales and use taxes, so that you lose more money when you spend, or things like limits in programs that provide healthcare, housing, and other things that you need. We won’t delve deeply into taxes in this article, but spending time with a financial planner to look at tax strategies will likely save you far more than the sessions cost.
Large, unexpected expenses are a risk few really contemplate when doing their risk management and really are one of the biggest risks you’ll face. A big one people miss is healthcare, where you develop a condition that requires an expensive surgery or expensive prescription drugs and therapies. The need to live in an assisted living facility or a nursing home is another cost people ignore. People ignore these probably because they really don’t want to pay for them. Even though they would never have relied on charity for things like food or housing, most people are perfectly happy to pay nothing for a surgery or a nursing home, even if they have the assets to cover them.
The Portfolio for Retirement Investing
Investing in retirement to deal with the risk of losing money because your assets decline is all about diversification and giving yourself options on where you get the money you use for living expenses. In the past we presented the Master Stock Portfolio (MSP), which is a portfolio to use as a starting point when you’re growing wealth. To review:
The MSP is comprised of:
VLCAX – The Vanguard Large Cap Index Stock Fund
VEVFX – The Vanguard Small Cap Explorer Value Fund
VTMGX – Vanguard Developed Markets Index Fund
VEMAX – Vanguard Emerging Markets Stock Index Fund
These are all mutual funds, meaning that investors send in their money and a professional money manager invests it for them as a group. This allows these investors to be invested in many different stocks without the fees and investment money it would require to buy that many stocks individually. Note that this makes it easy for the investors because they just need to choose and buy one fund instead of hundreds of individual stocks. With mutual funds there is normally a minimum you must invest to start. After that, you can normally send in money in any amount and add to your investment.
The first fund, VLCAX, is a large cap index stock fund. “Large cap” means that they invest in large companies, and these would be primarily US companies. This would be stocks like Google, Amazon, Nvidia, Bank of America, and General Motors. “Index” means that they buy based on a list of stocks designed to follow what that segment of the market is doing rather than having a manager pick which stocks to buy. This makes costs very low, increasing your returns.
The second fund, VEVFX, is a fund that invests in small cap value stocks. This is also an index fund, keeping costs low. “Small cap” stocks are small stocks, most of which you probably have never heard of. Examples you may have heard of in this fund are Yelp, Under Armour, Inc., and Mister Car Wash. “Value” means that it is stocks that are cheap compared to the perceived value of the company. These companies are much more likely to go bankrupt than any of the large cap stocks, but those that do well will grow much faster than any of the large cap companies and therefore provide a much larger return. On balance, this mutual fund will likely outperform the large cap mutual fund over long periods of time.
You hold these small stocks to benefit from their higher returns even though the risk of any one of them failing is much greater. The risk is only worth it because of the large number of stocks you hold. More fail, but those that do well, do very well, so they make up for the failing stocks.
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The third fund, VTMGX, invests in non-US stocks. Where the first two funds are buying mainly US stocks, these look elsewhere in the world. This fund only buys in developed countries which are fairly stable and predictable. It is not likely that a coup will change the government or the state will confiscate private property. Over long periods of time, this fund should perform a lot like the Large Cap US stock fund. Because these stocks may be doing well when the US stocks are doing poorly and vice-versa, holding this fund helps to smooth out the returns of your portfolio.
The last fund, VEMAX, is also a non-US stock fund. This one, however, buys into developing countries. These are countries that are not as stable but are showing growth. The hope here is that these countries will become developed while you own the fund. Because they’re coming from nothing, there is a huge amount of potential growth that can occur. There is a lot of risk, however, that any of these companies can survive, given both an unstable economy and an unstable social environment. You’ll notice that we tend to limit how much of our portfolio is comprised of this fund.
Creating the Master Retirement Portfolio
The MSP is a good starting point for your retirement portfolio. The issue, however, is that if stocks decline, all of these assets may decline in tandem. You’ll then be left selling funds and pulling out money while they are down. To avoid this risk, you should add other types of assets. These include real-estate, bonds/income stocks, and cash assets. This won’t eliminate your risk entirely, since assets do tend to go down together, but at least it will reduce the risk.
For example, using the Vanguard funds again, you could add:
VCOBX – The Vanguard Core Bond Fund
VGSLX The Vanguard Real Estate Index Fund Admiral Shares
Bank CDs/Money Market Fund
We’ll call this portfolio with these additions the Master Retirement Portfolio (MRP).
VCOBX is a bond fund that buys both government and corporate bonds that are short, intermediate, and long term. The bonds it focuses on are called “investment grade,” meaning they are considered to be safer than other types of bonds. Average yield on the bonds is around 4.5%, so they create an income stream of around 4.5% is addition to any of the capital gains they get from selling or having bonds redeemed at a higher price than they paid for them. Long-term these returns will lag stocks, but the yield will help stabilize the fund and make it less volatile. There will be times when stocks are declining while this fund holds firm or even rises in price.
VGSLX is a fund that invests in REITs, which are entities that buy large groups of real-estate properties. This will mean that you will have rents coming in in addition to capital gains from the properties. Again, the value of this fund will fluctuate, but having the income from rents will help you out at times when stocks are falling, making your overall portfolio less risky. Overall, the long-term risks for REITs are about the same as they are for stocks.
Of course, CDs and money market funds are just ways to hold cash that pay you a reasonable return. You’re allowing the bank to put restrictions on access to your money and agreeing to leave the money in the bank for longer periods of time, so they pay you additional interest in return. The returns you’ll get from these assets will be less than everything else and actually you will lose money to inflation over time, but money you have here has very little risk of being lost. It will be there when you need it.
If you’d like to learn more about how to decide how much you should put in different types of assets, Sample Mutual Fund Portfolios gives lots of information and examples of how to make allocations for all sorts of different goals, including retirement.)
Using the MRP
When investing in general you want to choose the asset that will pay the highest expected return for the time period in which you are investing. This is the asset that will pay you the most over your investment period. For short periods of time, like a year or two, stocks may be up or down. So the return from a stock portfolio could be 20%, but it could also be -20%. Stocks are therefore not a good investment for short periods of time.
A one-year bank CD paying 3%, however, will return 3%. Unless the country collapses and all the banks go bankrupt, you will get 3%. It is therefore a good investment if you have one year before you truly need the money.
For money you don’t need for ten years or more, stocks will generally provide the highest return. By holding for at least ten years, you’re providing time for all of the short-term volatility to run it’s course and then the long-term growth of the economy will cause a gain. On average, annualized returns of around 10% have been seen in stocks over the last several decades. This can change if the economy starts growing slower or faster, but it has held fairly steady with a few significant periods of stagnation. This will be better than the 3% return you could get from a bank CD. Of course, sometimes the return will only be 3-5% from stocks in a ten year period, but still the average gain you would see would be higher in stocks than a CD. So, when deciding how much to allocate to each component of the RSP, think about when you will need the money and allocate it appropriately.
Another factor to consider is your tolerance for risk. Stocks can and do change price rapidly where things like bank CDs are steady and predictable. Bonds are somewhere in between. It does no good to invest in volatile assets like stocks if you are going to get scared and sell them when the markets decline 10 or 20%. This will happen if you hold for more than a few years, and you could see 30% or 40% declines. Maybe more. But, given that the long-term averages are positive, stocks have always recovered back to where they were and gone higher. If you get out when they drop, however, you lock in your losses.
If you’re the kind of person who would see a 20% drop in your retirement account and sell it all, having a high stock position isn’t for you. You will be giving up the returns you could have gotten if you held stocks long-term, but if you aren’t going to hold, you’ll never see those returns. You should still have a portion in stocks, but a smaller allocation and you should learn to look at your whole portfolio and not just the portion in stocks when evaluating how things are going. Yes, maybe your stock portfolio went down 30%, but overall you’re only down 3% because you have a lot of bank CDs, bonds, and other assets that didn’t decline.
An Example for Risk-Tolerant Investors
Let’s say that you need about 5% of your portfolio each year for living expenses in retirement. If you have a high tolerance for risk and know that you are going to hold your investment through any turmoil, your allocations at age 65 when you just retired might look like this:
VLCAX – The Vanguard Large Cap Index Stock Fund:15%
VEVFX – The Vanguard Small Cap Explorer Value Fund:5%
VTMGX – Vanguard Developed Markets Index Fund:15%
VEMAX – Vanguard Emerging Markets Stock Index Fund:0%
COBX – The Vanguard Core Bond Fund: 30%
VGSLX The Vanguard Real Estate Index Fund Admiral Shares: 20%
Bank CDs/Money Market Fund: 15%
Note that we have allocated 15% to money markets and CDs. This provides the money that you need for three years in cash assets. You might put money you need for the next 6 months in the money market so you could access it as needed. The rest you could have in 6 month, 1 year, 18 month CDs, etc… so that the money would earn the maximum interest rates and be unlocked when you need it over the next three years.
There is a 30% portion in the core bond fund. This investment will help offset the volatility in the stock portion of the portfolio. Because these are mid-term bonds, being redeemed in the 6 to10-year time frame, many of the bonds that were in the fund at the time when you started into retirement would start being redeemed in the fund around the time when you are starting to deplete the money you have in the cash assets. When this happens, the bond issuer would pay your fund the fixed, redemption price for the bond (usually $1000/bond). This means that even if the bond dropped in price while the fund held it, as long as the issuing company doesn’t go bankrupt, the original bond value would be repaid. Of course, the fund would buy new bonds, so there would be a variety of redemption dates.
You would still have 35% in stocks, split among large, small, US, and non-US. You also have 20% in REITs, that have returns approaching those of stocks but do not always move in tandem with stocks. This portion of your portfolio would grow over the 20 years after retirement, between ages 65 and 85. This provides growth to allow you to keep up with inflation.
As you aged, you’d sell from the stock portfolio and add to the cash and bond portfolio. Initially you would just be replenishing the cash position from the stock portion, but as you got closer to the end of your life where you no longer had the 10 to 15 years needed for stocks to recover from market drops, you’d add to your bond portfolio. This would allow the income you receive from those bonds to increase with time, keeping up with inflation and giving you more money for medical expenses as they grow in late life. If you lived to age 90, your portfolio might look like this:
VLCAX – The Vanguard Large Cap Index Stock Fund:3%
VEVFX – The Vanguard Small Cap Explorer Value Fund:0%
VTMGX – Vanguard Developed Markets Index Fund:2%
VEMAX – Vanguard Emerging Markets Stock Index Fund:0%
COBX – The Vanguard Core Bond Fund: 60%
VGSLX The Vanguard Real Estate Index Fund Admiral Shares: 5%
Bank CDs/Money Market Fund: 30%
Note that because the account value may have depleted over time and because your expenses would get higher as you age (medical, nursing, etc…) we’re assuming your expenses are now 120% of portfolio value, so 30% of portfolio represents three years of expenses. You might even want to have more cash than this since the danger from a big loss in investments (from your bonds in this case) is more severe than the loss of some potential investment gains at this stage.
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A Cautious Retirement Portfolio
Let’s say that you’re sacred of market losses and might sell out if stocks dropped? Here’s how you might adjust the portfolio above to make it less volatile:
VLCAX – The Vanguard Large Cap Index Stock Fund:10%
VEVFX – The Vanguard Small Cap Explorer Value Fund:0%
VTMGX – Vanguard Developed Markets Index Fund:10%
VEMAX – Vanguard Emerging Markets Stock Index Fund:0%
COBX – The Vanguard Core Bond Fund: 50%
VGSLX The Vanguard Real Estate Index Fund Admiral Shares: 10%
Bank CDs/Money Market Fund: 20%
Here we’ve reduced stock exposure, eliminated volatile small caps entirely, reduced REITs a little, and added to the bond and cash positions. The returns over a 30 year retirement for this portfolio would not be like they were for the standard one in the section above, but the fluctuations in this portfolio would also be a lot smaller. Just as above, you would adjust your allocations into more bonds from stocks and REITs as you aged.
Have a question? Please leave it in a comment. Follow me on Twitter to get news about new articles and find out what I’m investing in. @SmalllIvy
Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing..
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