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Does Asset Allocation Matter? (Will I Run Out of Money in Retirement?)

Since my recent posts discussing my own asset allocation and my thoughts on Treasury bonds vs. Vanguard’s Total Bond Market Fund, I’ve gotten a steady stream of emails about asset allocation–especially for retirees or soon-to-be retirees.

That’s good. It’s an important topic.

But I think it might be helpful to back up and remind ourselves that asset allocation isn’t everything. For example, any of the following factors can play a larger role than asset allocation in determining how likely you are to run out of money during retirement:

  1. How long your retirement lasts,
  2. What withdrawal rate you use (including amounts paid for mutual fund expenses, brokerage commissions, or advisor fees as part of your withdrawal rate),
  3. What portion of your portfolio you choose to annuitize, and
  4. Whether or not you make any big mistakes (bailing out near a market bottom, for instance).

Withdrawal Rate and Length of Retirement

Acting in combination, length of retirement and withdrawal rate are the most important factors as to whether you outlive your money or vice versa.

For example, if you’re looking at an expected retirement length of just 10 years, and you can afford to (and plan to) use a withdrawal rate of just 3%, then regardless of what asset allocation you use, it’s almost impossible for you to run out of money.

On the other extreme end of the spectrum, if your retirement could end up lasting 30 years or more, and you’re looking at a starting withdrawal rate of 8%, that’s a problem. Before fiddling with your asset allocation, you need to find a way to retire later and/or reduce your level of spending.

It’s only in the middle range–the “maybe I have enough, maybe I don’t” range–that asset allocation comes to play an important role.

Annuitizing (a Portion of) Your Portfolio

Next in order of importance comes the decision of how much of your portfolio to annuitize. [Reminder: A lifetime immediate fixed annuity with inflation adjustments functions very much like a pension--the annuity provider (an insurance company) pays you a predictable amount of money every year until you die, at which point the money disappears.]

If you decide to annuitize enough of your portfolio to completely satisfy your basic spending needs, then you can afford to use either a high-risk or low-risk allocation with the remainder of your portfolio–neither choice puts you at risk of running out.

Avoiding Mistakes

Finally, there’s the behavioral factor. You can choose an allocation that’s exactly perfect for your withdrawal rate and expected retirement length, but if you can’t stick to your allocation–specifically, if you bail out of stocks at a market low or go all-in on stocks at a market peak–you’re in for trouble. (That said, your likelihood of making mistakes may of course be impacted by your asset allocation.)

Covering All Your Bases

Asset allocation is important. But even the most well-researched, well-planned allocation can’t create a miracle, so be sure to tend to the other aspects of investment success as well:

  • Keep your spending under control so that you can save enough during your working years and withdraw little enough during your retirement years.
  • If you’re in the range where you’re not confident a typical stock/bond portfolio will be able to sustain the level of spending you’d like, consider annuitizing part of your portfolio.
  • Stick to the plan. Don’t get fearful or greedy at the wrong time.

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Comments

  1. Hi Mike

    Under Asset Allocation and preparing for retirement I would add:

    Make sure that you have a withdrawal strategy that is in place BEFORE you retire.

    Money you will need in the next 1-3 years should be in a liquid [spendable] form: money market or checking/savings account, plus perhaps a couple CDs maturing in years 2 and 3. The reason for this is that you do not want to be planning to retire [for example, in January 2008] and have everything in stocks and longer term bonds just as the market breaks. Your funds will need time to recover if your timing is unlucky and you retire into or just before the beginning of a bear market. Having cash will not only prevent you from having to sell low, or worrying how you will retire on time, it will also help you stick to your asset allocation and investment plan when things get crazy.

    I just gave away my second copy of your “Can I Retire?” book, so I will have to buy a few more [several of my wife's co-workers announced their retirement].

    Thanks,

    Jim

  2. “Make sure that you have a withdrawal strategy that is in place BEFORE you retire. “
    Indeed. A very good point, Jim.

    And thank you for using the book as a gift! I hope the recipients find it useful. :)

  3. Jim, Mike:

    I expect to retire in about 3-4 years, and most of my funds are in a Vanguard traditional IRA, with smaller amounts in cash and a Roth IRA. To meet the goal of putting 1-3 years of expenses in a money market or checking/savings, would I be better withdrawing some of the money in a year or two and paying the taxes, or keeping the same amount in a money market fund (or perhaps even a short-term treasury fund) within the tIRA? (I do not plan to touch the Roth too soon, as it has the most potential to grow tax-free.)

    Thanks.

  4. Hi Larry.

    For the most part, there’s no reason to pull money out of an IRA (Roth or traditional) until it’s time to spend it. (Noteworthy exception being pulling money out of a traditional IRA in order to “fill up” a tax bracket if you’re currently in a lower bracket than you expect to be in later. But that seems unlikely to be the case for someone a few years from retirement.)

    In other words, I’d probably keep it in the IRA–just in something very low risk within that IRA.

  5. Hello Larry

    Sorry, my comments were misleading. I *should* have said, “…have a strategy for cash set up before you [have to] start withdrawing money” instead of “before you retire” [and, Sometimes, we have to retire earlier than we'd like].

    My wife and I are planning to leave our regular IRA [non-Roth] and 403[b] untouched until we have to start making Required Minimum Distribution withdrawals at age 70 1/5. My wife is a teacher and closing in on retirement [as are several of her co-workers: they are the ones whom I have given my copies of Mike's book to]. We hope to retire in stages, first pensions and part time work, later Social Security, and then the supplemental retirement accounts [IRA and 403(b)] last – as a hedge against inflation and longevity, and also instead of long term care policies, which I consider an expensive and unproven product.

    Also, do not forget to look at retirement finance as a whole: I have read arguments that you do not need a separate emergency or “rainy-day” fund once you retire [because the biggest reason to have one is job loss], but in that case you might need a little extra buffer in your cash part of your over-all Asset Allocation. If you have a good emergency fund make sure to count that, and any taxable savings and checking accounts or CDs as part of your cash!

    Everyone has a different situation. We have been completely debt free since right after my layoff in 2002, but most of our home appliances are over 20 [and in one case over 40] years old, so I am replacing some of them right now, mostly because a couple we know is moving to a retirement community and gave them to us.

    Mike’s book [Can I Retire?] would probably provide you some answers as well as a few questions which you may not have thought of. I found that to be true of each of his books [I just finished the one on Income Tax and learned a couple things despite doing my own taxes for the past 40 years].

    Best wishes to you, Larry.

    Jim

If you want to discuss this article, I recommend starting a conversation over at the Bogleheads investing forum.
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