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When people think about building a retirement portfolio, the conversation often starts with a percentage.
“How much should I have in stocks and bonds?”
Maybe it's 60/40. Maybe it's 70/30 or even 50/50. Many people complete a risk questionnaire to decide which allocation is “right” for them.
I prefer to start somewhere else: What does the retirement plan actually require the portfolio to provide?
Before deciding how much to invest in stocks, bonds, or cash, I want to understand when the money will be needed, how much will be needed, and what other sources of income will be available along the way. This is the basic idea behind an asset-liability approach to retirement investing.
Rather than starting with a portfolio allocation and trying to make the retirement plan fit, we start with the retirement plan's future cash-flow needs and build the portfolio around them.
In this example, I'll walk through how I approach this for Robert and Denise, a hypothetical couple whose retirement plan we've been building throughout this series.
By the time we're ready to build the portfolio, we've already done a lot of work. We know when Robert and Denise plan to retire, how much they expect to spend, their estimated healthcare costs and taxes, and the larger expenses they expect to encounter throughout retirement. We've also incorporated their expected Social Security benefits.
Now we can answer a much more useful question: How much money will their portfolio actually need to provide each year?
Early in retirement, the portfolio will cover a relatively large portion of their cash-flow needs. That's because Robert has chosen to delay Social Security, so the portfolio needs to provide more income during those initial years.
When Robert's Social Security begins, the portfolio doesn't suddenly provide them with a larger paycheck. Instead, the amount they need to withdraw from the portfolio decreases by the amount of Social Security coming in. When Denise's Social Security begins the following year, the portfolio withdrawal decreases again.
This is an important concept when evaluating retirement withdrawals. A higher withdrawal rate during the early years of retirement isn't necessarily a problem if it's part of the plan. In Robert and Denise's case, the portfolio is intentionally filling the gap until additional guaranteed income begins.
That's why I don't think it's particularly useful to look at a retirement portfolio in isolation and say, “Your risk tolerance questionnaire says X, therefore your portfolio needs to look like Y.” The cash flows matter.
There are several ways to think about investing in retirement. One common approach is a total-return approach, where the focus is primarily on building a diversified portfolio designed to generate an appropriate long-term return. The allocation may then be adjusted based on factors such as risk tolerance, time horizon, and expected spending.
An asset-liability approach starts from the other direction. Instead of asking, “What portfolio should we own?” we first ask, “What future spending needs do we need to fund?”
For Robert and Denise, we know they need money next year. We know they'll need money five years from now. We know they'll need money ten years from now. We also know that some expenses are essential while others are discretionary, and that Social Security will eventually cover part of their income needs.
That information allows us to match different parts of the portfolio with different jobs.
This doesn't mean trying to eliminate investment risk. Instead, it's about making sure that the investments being used for near-term spending aren't being asked to do the same job as investments intended to provide long-term growth.
I generally think about three broad categories within a retirement portfolio: cash, bonds and stocks.
Cash and money market funds are useful for the most immediate needs. You earn interest on the money, but the dollar value generally doesn't fluctuate the way a stock or bond investment does.
Bonds can be used for near- and intermediate-term cash-flow needs. They generally have less volatility than stocks, although they aren't risk-free and their market values can fluctuate. This is where I often use a bond ladder, purchasing individual bonds with different maturity dates so that cash becomes available at predetermined points in the future.
Stocks serve a different purpose. They're the long-term growth engine of the portfolio. The further into the future we go, the more important long-term growth becomes, and the more reasonable it can be to accept the short-term volatility that comes with stocks.
The key is that these investments have different jobs. We're not simply deciding that someone is 40% in bonds because they're retired. We're asking what the bonds need to accomplish and how much time the stock portfolio has to grow before those assets are needed.
This distinction becomes particularly important when we're building a portfolio around specific future cash flows.
Suppose Robert and Denise purchase a $100,000 U.S. Treasury bond that matures in 2030 and hold it until maturity. During that time, the market value of the bond will fluctuate as interest rates change. If interest rates rise, the market value of the bond will generally fall.
However, assuming the issuer fulfills its obligation, if they hold the bond until maturity, the bond pays its stated principal. That maturity date can therefore be useful when we're planning future cash flows.
If we know Robert and Denise will need a certain amount of cash in 2030, we can purchase an individual bond that matures around that time. When the bond matures, the proceeds become cash that can then be used for their planned expenses.
There are still risks involved. Individual bonds aren't guaranteed investments, and credit risk, reinvestment risk, liquidity and other factors matter. U.S. Treasury securities are backed by the U.S. government, but their market values can still fluctuate before maturity.
Bond funds work differently. A bond fund owns a portfolio of bonds and generally doesn't have one specific maturity date when the entire investment turns back into cash. As interest rates change, the value of the bonds held by the fund can change, which affects the fund's net asset value.
That doesn't make bond funds inherently bad. They can be efficient, diversified and useful in many portfolios. But when I'm trying to match specific future retirement cash flows with specific investments, I find the maturity dates of individual bonds particularly useful.
There isn't one universal answer to how many years of retirement spending should be covered by bonds.
For Robert and Denise, I want to look at several possibilities. In this case, we're comparing a five-year bond ladder with a seven-year bond ladder.
The seven-year approach dedicates more of the portfolio to cash and fixed income. The five-year approach leaves more money invested in stocks, giving the portfolio more exposure to long-term growth.
So the decision isn't really about whether five years or seven years is “correct.” It's about the tradeoff between having a longer runway of known fixed-income cash flows and maintaining greater exposure to long-term growth assets.
I don't start by saying, “Every retiree should have seven years of bonds.” We build the retirement plan first, identify the cash-flow needs, and then determine what the portfolio needs to accomplish.
One of the biggest concerns for someone retiring is what happens if the stock market falls immediately after retirement.
If someone is withdrawing money from their portfolio while simultaneously experiencing a major decline in stocks, selling stocks to fund those withdrawals can make the recovery more difficult. This is one reason sequence-of-returns risk is so important in retirement planning.
A bond ladder can provide a runway.
Imagine Robert and Denise retire and the stock market immediately experiences a severe bear market. If we've already set aside several years of their expected cash-flow needs in cash and maturing bonds, we don't necessarily need to sell stocks immediately to pay their bills.
Instead, the fixed-income portion of the portfolio can provide the planned cash flows while the stock portfolio has time to recover.
Historically, major market downturns have varied considerably in both severity and recovery time. That's why the appropriate runway depends on the specific retirement plan, the household's flexibility and how much risk they're willing and able to accept.
The further out the cash flow, the less useful it becomes to try to lock everything into today's interest rates.
At some point, the portfolio needs a long-term growth engine. That's where stocks come in.
If we've already covered the near-term and intermediate-term cash flows with cash and bonds, money needed further into the future can remain invested for long-term growth. A diversified stock portfolio can experience significant declines, so there are no guarantees, but having a longer time horizon gives those investments more opportunity to recover from temporary declines and participate in long-term economic growth.
The goal is to give those investments time to do their job.
A 60/40 portfolio—60% stocks and 40% bonds—is an easy concept to understand, and there are circumstances where an allocation around that level may make sense.
But retirement itself doesn't automatically tell us what someone's stock-to-bond allocation should be.
Consider two retirees with the exact same $3 million portfolio. If one needs $150,000 from the portfolio next year while the other doesn't expect to need the money for ten years, their portfolios don't necessarily need to look identical.
Their cash-flow needs are different.
That's the information I want to use when determining the portfolio structure. Instead of applying the same allocation to every household, we can look at when the money is actually needed and determine which investments are appropriate for each portion of the plan.
It's not just about how much is invested in stocks and bonds. It's also about where those investments are held.
For Robert and Denise, we're projecting that their taxable account will be used earlier in retirement. Their IRA will provide cash flows later, while their Roth account may not be needed for many years.
That gives us an opportunity to coordinate the investments across their accounts.
For example, if their Roth assets aren't expected to be needed for many years, they may be positioned to serve as part of the long-term growth portion of the portfolio. Meanwhile, accounts expected to fund near-term spending can hold more of the cash and fixed-income investments needed for those withdrawals.
There is no portfolio construction strategy that eliminates investment risk.
Stocks can fall. Bond values can fall. Interest rates can change. Inflation can be higher than expected. Retirement can last much longer than anticipated.
The goal is to recognize these risks and build a plan around them.
For me, that means starting with the cash flows: What money do you need? When do you need it? What other income will you receive? Which expenses are essential? Which are discretionary? And how much flexibility does the plan have?
Once we answer those questions, the portfolio starts to make a lot more sense.
Instead of asking, “What percentage should I have in stocks?” we can ask a more useful question:
“What does each part of my portfolio need to accomplish?”
That's the foundation of an asset-liability approach to retirement investing.
For Robert and Denise, it gives us a portfolio designed around their actual retirement rather than around a generic allocation.
An asset-liability approach starts with a retiree's future spending needs and income sources before determining how the portfolio should be invested. The goal is to match investments with the timing and nature of future cash-flow needs rather than starting with a predetermined stock-to-bond allocation.
There isn't a universal number of years that works for every retiree. The appropriate amount depends on factors such as planned spending, Social Security income, portfolio size, flexibility in discretionary spending, and tolerance for investment volatility. Some retirement plans may use a five-year bond ladder, while others may call for a longer runway.
A bond ladder is a portfolio of individual bonds with different maturity dates. As each bond matures, the proceeds can be used to fund spending needs or reinvested. This can help match fixed-income investments with specific future cash-flow needs.
An individual bond has a specific maturity date. If the bond is held until maturity and the issuer fulfills its obligation, the investor receives the bond's stated principal. A bond fund owns a portfolio of bonds and generally doesn't have one maturity date when the entire investment returns to cash. Both can fluctuate in value as interest rates change.
A 60/40 portfolio can be appropriate for some investors, but retirement alone doesn't determine the appropriate stock-to-bond allocation. A retirement portfolio can instead be constructed around the household's specific cash-flow needs, other sources of income, time horizon and risk considerations.
It can make sense for different accounts to have different investment roles depending on when the assets are expected to be used, tax considerations and the overall retirement-income strategy. For example, assets that aren't expected to be needed for many years may have a greater role in the portfolio's long-term growth allocation.
Applying the same allocation to every account doesn't necessarily account for when the money will actually be needed. Coordinating investments across accounts can allow near-term spending needs to be funded with more stable assets while assets intended for long-term needs remain invested for growth.
This article is provided for educational and informational purposes only and is not intended to provide individualized investment, tax, legal, or financial planning advice. The examples of Robert and Denise are hypothetical and are used for illustrative purposes only. Actual investment strategies and portfolio allocations should be based on an individual's specific circumstances, goals, time horizon, risk tolerance, and financial plan.
Investing involves risk, including the possible loss of principal. The value of stocks, bonds, bond funds, and other investments can fluctuate. Individual bonds held to maturity are subject to credit risk and other risks, and receiving the stated principal at maturity assumes the issuer fulfills its obligations. Past performance is not indicative of future results.
This article is not a recommendation to purchase any particular security or investment product.
Bugle Valley, LLC is an investment adviser registered with the applicable state securities authorities. Registration does not imply a certain level of skill or training.
Beau Kemp, CFP®, RMA®
Founder, Financial Advisor
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