A new client recently asked me, “Do most of your clients reduce the equity allocation of their investment portfolio as they get older?”
I began my answer with the proverbial, “It depends.”
I told him that while many of my clients reduce the equity portion of their investment portfolio as they approach retirement, this isn’t always the case. I explained to him that in situations where this is done, the often-stated goal of having a more conservative portfolio isn’t usually the driving force.
Traditional portfolio design
The importance of equities for the purpose of long-term growth and providing a hedge against inflation is a long-standing tenet of portfolio construction. Equities include, but aren’t limited to, stocks, equity mutual funds, and equity exchange-traded funds.
Subject to the investment objective of a particular portfolio and each individual’s risk tolerance level, equities typically represent 40% to 70% of the value of a portfolio. Although there are exceptions, this is the case whether you’re 35 or 75.
The recognition of the need for income replacement needs to be a key parameter when constructing a portfolio as you get older. Beginning at age 40 to 45, you should begin planning for how you will replace your paycheck, or draw, if you’re self-employed when you retire.
Transition from investment to income allocation mind-set
Given the goal of income replacement, income allocation should play an increasingly important role in influencing portfolio design as you get closer to retirement. There are three reasons for starting this process sooner than later:
- Retirement can last two to four decades, with 25-plus years becoming the norm — especially for couples.
- Earlier versus later planning will be beneficial if you retire early.
- Retirement income stream amounts will be greater with more years of deferral.
The foregoing reasons dictate that our portfolio design mind-set changes from investment asset management to retirement income management in a timely manner. Different, and perhaps more secure, types of investments will need to be included in most portfolios to generate adequate income for the duration of retirement.
Projected retirement income shortfalls
How do you transition from investment asset to retirement income management? A two-step process is required. Step 1 involves calculating projected annual retirement income shortfalls. After deciding on a projected retirement date or range of dates, the following two questions need to be answered:
- What is your projected annual total of planned and unplanned expenses adjusted for inflation?
- What are your projected annual sources and after-tax amounts of sustainable income?
Planned expenses include recurring and nonrecurring items such as auto and appliance replacement and home improvements. Health care and extended care expenses shouldn’t be overlooked and, furthermore, need to be adjusted using a higher inflation rate than other types of expenses.
Sustainable is the key word to keep in mind when answering question No. 2. Although it has been debated in recent years, Social Security is generally considered to be a source of income that, once it begins, will continue for the duration of retirement. Other sources of sustainable income include public and private pensions and fixed-income annuities.
After you determine the answer to both questions, you can subtract projected annual after-tax amounts of sustainable income from projected annual planned and unplanned expenses adjusted for inflation to arrive at projected annual retirement income shortfalls.
Retirement portfolio design
Once you have calculated your projected annual retirement income shortfalls, you’re ready to proceed to Step 2 — retirement portfolio design. The types of investments that should be included in your retirement portfolio will be determined by the timing of projected income shortfalls and amounts of same.
Timing of projected shortages is critical when it comes to retirement portfolio design. This includes the year(s) in which shortfalls are projected to occur as well as their projected duration, e.g., one year, two years, three years, etc.
Projected shortfalls occurring later in retirement should be given high priority. Two common types of shortfalls in this stage are those related to longevity and extended care. Insurance solutions are often an efficient use of portfolio dollars to address both situations. Deferred fixed-income annuities and long-term care insurance, respectively, are suitable tools for mitigating the deficiencies related to these two events.
Other projected income deficiencies can be minimized using a combination of portfolio withdrawal and fixed income annuity strategies. The appropriate strategies will depend upon the timing and amounts of projected shortages, estate-planning considerations, and, in the case of annuities, specialized knowledge and experience. Income tax planning expertise is helpful when analyzing different types of fixed-income annuities and determining placement in nonretirement versus retirement accounts.
So what should your ideal retirement portfolio look like? As you can appreciate after reading this article, there’s no one-size-fits-all solution. A different mind-set and set of skills is required to design and manage a portfolio that will result in the optimal timing and generation of after-tax income needed to match projected annual inflation-adjusted expenses for the duration of retirement.
DISCLOSURE: Robert Klein is licensed as a Resident Insurance Producer in California (License #0708321).
Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. Bob is also the sole proprietor of Robert Klein, CPA. Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies to optimize the longevity of his clients’ after-tax retirement income and assets. He does this as an independent financial advisor using customized holistic planning solutions based on each client’s needs and personality.