Approaching retirement? How should you allocate your investments so that you can protect what you have while also growing your nest egg in retirement? This is a common question with a complicated answer. There really is no single allocation that is best for someone. It really will depend on your risk tolerance, risk capacity, and retirement income needs. While there are some ‘rules of the road’ to help you, you won’t likely find an Easy Button at Staples to help.
Risk tolerance describes your comfort level with investment variability (sometimes referred to as volatility and measured by standard deviation which you’ll sometimes see listed in an investment fact sheet at Morningstar).
Risk capacity refers to your ability to take on risks after looking at the big picture of your finances. Example: You have a small nest eff and may have a high risk tolerance and willing to accept sharp ups and downs with your investments. But you lack an adequate emergency reserve account or are missing some other critical insurance coverage. In this case, you lack the capacity to take on lots of risk. Think of it in these terms: Your spirit is willing but the body is weak.
Finally, as you consider growing your nest egg in retirement, you have to consider what you need your investments to produce to support your lifestyle. There are rules of thumb (example: withdraw 4% of your total investments each year and it may last you 30 years in retirement). A better way is to factor in all that you’ll need to cover your fixed overhead and discretionary (i.e. fun) cash needs. Make a best guess about your life expectancy based on your health, life style, and family history, or use online tools based on actuarial tables (see www.longevityillustrator.org). Then add up all your fixed or guaranteed income sources like pensions, Social Security, rent received. There will be a gap and that is what the investment portfolio needs to fill – preferably from gains, interest, and dividends. But if you’re short, you’ll probably need to take it out of the principal amounts you’re investing.
All that being said, you should probably aim for setting aside a bucket into cash or near-cash investments (money markets, CDs, ultra short-term bonds) equal to a minimum of six months up to 3 years of fixed expenses. The exact amount will depend on your risk tolerance.
Then with your remaining investable resources you should aim for an amount in equities equal to about 115 minus the age of the youngest spouse. There’s a general rule of thumb that says 100 minus age but with people living longer and insurance companies using life expectancy tables of 120, you’d be safer using a higher number. As uncomfortable as it may make you, the reality is that the best investments to counter the risk of inflation in retirement will be owning stocks (individually or through equity-focused mutual funds or Exchange Traded Funds). This is the allocation that offers you the strongest opportunity to growing your nest egg in retirement.
With the balance you can allocate to fixed-income (bond funds, bond ETFs, or individual bonds).
Given low current interest rates, you may want to consider a higher allocation to equities. As the Fed increases rates, you’re likely to see the price on existing bonds or bond funds go down (the price of bonds moves in the opposite direction of market interest rates). While there’s no “safe” investment, you may find stocks or funds that invest in dividend-paying companies can be a lower risk option. These include “Steady Eddies” like utilities and large consumer product companies.
And if it’s yield that you’re looking for, you should consider adding an allocation to real estate-oriented funds.
For a more specific allocation tailored to your needs, consider reaching out to a qualified financial planner or investment adviser.