The Bogleheads' Guide to Retirement Planning (25 page)

Just as you have a regular health checkup to be sure your body is healthy, you should have a regular portfolio checkup to be sure your investments are working according to your plan. You should check your allocation to see if you need to rebalance. Your IPS should have your rebalancing schedule. If your workload varies by season, the rebalancing date should be in the quiet season to make it easier to manage your investments. Otherwise, use an easy-to-remember date, such as every January when you make your IRA contribution, every April after you file your taxes, or your birthday.

You should review your rebalancing plan even if rebalancing is automatic in the balanced mutual fund you selected. Your financial situation may have changed, and perhaps you need a new asset allocation. Perhaps you got a new job, had children, received an inheritance, or had a large unexpected expense. Revisions to your statement should represent where you are now and where you are going in the long run. You might include in your statement a sentence such as “If there is no substantial change in my financial situation, I will wait at least three months between changing the statement and making the corresponding change in my investments, and I will review the change to the statement again at that time.”

Your risk tolerance is the maximum amount of account variability that you can stand during the worst market conditions. To determine your risk tolerance, you must consider your ability and need to take risk. Bear markets such as 1973-1974, 2000-2002, and 2007-2008 can cut the value of a stock portfolio in half; therefore, your stock allocation should be no more than twice the amount you can tolerate losing. Risk and return are directly related. Your asset allocation should balance your
need
to take risk with your
ability
to withstand the ups and downs of the market.
Need
can be determined via basic financial planning formulas. If you’re young, you have the benefit of many years of compounding, so your need to take risks is low. On the other hand, if you are older and your portfolio size is small, your need to take risks is high because you will need a higher return to achieve your retirement goal. Now, the opposite is true for ability to take risks. Young people can take more risks because they have many income-earning years ahead. On the other hand, older people have less ability to take risks because their working years are shrinking.

For people closer to retirement, it may be possible to more closely determine need. First, estimate approximately how much income you will need annually after retirement. For example, assume you need $100,000 per year. Next, look at any pensions or Social Security benefits that will provide a source of income. If a pension provides $30,000 per year and Social Security provides an additional $20,000 per year, then the portfolio would need to provide an extra $50,000 each year. Using the 4 percent withdrawal rate discussed earlier, to generate $50,000 per year at 4 percent requires a minimum portfolio size of $1.25 million. How close are you to your goal? Chapter 12 covers planning for withdrawals and calculating spending patterns in more detail.

Turning to
ability
, this is your ability to withstand the ups and downs of the market without getting nervous and making changes to your asset allocation. Selling in the face of a decline is probably the worst thing you can do.
Figure 9.1
is a table portfolio based on a severe bear market, showing the loss that should be expected on a $100,000 portfolio for various stock/bond allocations when the next deep bear market occurs.

Source:
Morningstar, Inc.

You can also get help in determining your asset allocation by utilizing the online risk assessment tools available at
www.vanguard.com
. In addition, there are simpler ways to determine an asset allocation. Vanguard founder John C. Bogle recommends “your age in bonds.” For example, if you are 40 years old, hold 40 percent in bonds and the rest in stocks. There are other variations:

Your investment plan should reflect a lowering of risk as you approach the amount needed at retirement. There are several ways of doing this. The simplest way is to use an age-appropriate life cycle mutual fund such as one of Vanguard Target Retirement Funds. A target retirement fund lowers risk automatically over time by decreasing equities and increasing fixed income. A common way to manage risk is to do it yourself. If you’re a younger investor, you will probably want to start with a relatively high allocation to stocks because of the trade-off between risk and expected return and then gradually reduce the stock allocation as you approach your retirement goal. However, we do not recommend more than 90 percent in equities even for young investors.

During a bear market, how much your account will lose in value depends on how much money you have invested at the time and your asset allocation. If you are in midcareer with $500,000 invested, a 20 percent decline in the financial markets will cause a decline in your assets of $100,000. If you are about to retire with a $1 million portfolio, a 10 percent decline in the markets will cause a decline in your assets of $100,000. Either way, a bear market took away the same amount of value. In this scenario, if you suffered the 20 percent loss midcareer, you haven’t lost any more money than if you suffered a 10 percent loss prior to retirement.

No one wants to sustain a 10 percent loss, let alone a 20 percent loss. That is why time
in
the market is important. The more time you have to invest, the greater the likelihood that you will benefit from the long-term growth of the stock market.
Table 9.1
shows that the U.S. stock market has many bad periods as measured in real returns (returns adjusted for inflation). There have been 26 negative real return periods over rolling 5-year periods since 1871, and 11 negative real return periods over 10-year rolling periods. But there has not been a 20-year negative real return period since 1871.

Source:
Robert Shiller,
www.econ.yale.edu

The implication for these numbers are that if you have 20 years left to invest, then you should have at least some money in stocks. Even if you are nearing retirement, you hopefully have 20 years left to live, and if you don’t, your heirs may. Accordingly, you should still have the growth potential of equities in a portion of your retirement portfolio. The money you are planning to spend in the next few years should be in low-risk investments, but at least a portion of the remaining funds should be in stocks.

If you are considering retiring but do not have the resources, you might choose to delay retirement. This would give you more time to contribute to your retirement savings and allow the portfolio to grow, and that combination will increase the number of years you can stay solvent in retirement. For example, assume you have $500,000 at age 65 and retire. If your portfolio earns 6 percent per year and you take out $40,000 per year, you will run out of money at age 87. In contrast, if you work for one more year and save an extra $5,000, plus 6 percent growth in your portfolio, you will have $535,000 at age 66. If you then retire and take out $40,000 per year, you will not run out of money until age 93. One year of extra work and savings extended your retirement solvency for six years.

Many investment companies now offer life cycle funds, also called target-date funds. They are designed to adjust their allocation automatically from an aggressive allocation to a less aggressive allocation as the target retirement date approaches. Typically, these funds are very well diversified, investing in U.S. stocks, foreign stocks, and bonds. There are many different life cycle funds available, and they all follow different glide paths to reduce equity exposure over the years. It is wise to understand the glide path used on the fund you are considering.

It is usually easy to tell whether life cycle funds are available in a retirement plan. They generally have a name such as Target Retirement 2030. Funds without a date in their name are usually not life cycle funds. The prospectus of a life cycle fund should also explain how its glide path will decrease risk over time.
Figure 9.2
shows the equity allocations from two providers of low-cost life cycle funds, the Thrift Savings Plan (TSP) L Funds and Vanguard’s Target Retirement Funds.

If you have the option of using life cycle funds in either your 401(k) or your IRA, they are a great way to invest. A small investment can give you a broadly diversified portfolio, and you do not need to meet the minimums in individual asset class funds. Plus, you do not need to spend time rebalancing among multiple funds each year. Even if you do not plan to use these life cycle funds over the long-term, you can start with them at first and then branch out into individual asset class funds as your portfolio grows.

Source:
www.tsp.gov
and
www.vanguard.com

Make sure you are comfortable with the asset allocation of the particular life cycle fund you select. Many life cycle funds have very large allocations to equity for the more distant target dates, such as 2040 and 2050. Both the TSP L and the Vanguard Target Retirement Fund that are 40 years out have 90 percent stock. Not all investors are comfortable with that much risk. If you want to take less risk, you can always choose a life cycle fund with a target date earlier than your expected retirement date.

Life cycle funds do have disadvantages. Target-date funds are not very tax-efficient. They include taxable bonds that generate dividends taxed at high ordinary income tax rates, and the frequent rebalancing generates short-term capital gains. As a result, life cycle funds do not work well if you have a mixture of taxable and tax-advantaged accounts. If part of your portfolio is taxable, you want to manage your portfolio to minimize taxes, which means putting tax-efficient funds, such as total stock market index funds, in your taxable account, and tax-inefficient funds, such as bond funds, in your tax-advantaged accounts.

Life cycle funds are designed to provide the investor with a nicely diversified portfolio with a single fund. Therefore, they work well only if they are all or almost all of your portfolio. If a significant part of your portfolio is in a non-life cycle fund, then you will have to adjust your overall asset allocation at least annually to get the portfolio in balance, thus defeating the benefit of automatic rebalancing.