When & How to Transition your portfolio for Retirement
Your portfolio has a different job in retirement than it has pre-retirement. Pre-retirement, the job of your portfolio is to grow. In retirement, the job of your portfolio is to generate income (for most people).
Because the job is different, the allocation of your portfolio will need to be different. During growth mode your portfolio can be heavily exposed to aggressive-yet-volatile growth instruments, such as stocks (assuming you can stomach it, and you won’t undermine your portfolio by fleeing during market declines).
However, during income mode, the aggressive-yet-volatile growth instruments – stocks – can pose a challenge. Volatile stocks can quickly lose value during a market decline, and drawing income during this decline can permanently damage your portfolio’s ability to generate lifetime income.
So, during growth mode you can be very aggressive. During income mode you may need to be more conservative.
This does not mean that you should have no growth instruments in your retirement portfolio. You certainly should. It does, however, require you to have conservative instruments as well. These conservative instruments will provide you income during the market declines when your aggressive instruments need time to recover.
How much of your portfolio should be conservative when you retire? I address that in my video here.
In this article I want to address the question of when – When do you switch your allocation from growth mode to income mode? Should you do it the day before you retire? The year before? The decade before? Is it an immediate shift or a gradual transition? If it’s a transition, when should you start that transition?
I have my prescribed method which I will describe below, but there is more than one answer to this question. In fact, the answer will depend on your risk tolerance and how fixed your retirement date is.
To use an extreme example – if your retirement date is absolutely fixed and you want to ensure your portfolio is positioned to withstand even a great-depression scenario, then you will need to have your portfolio completely transitioned 10 years prior to retirement, and you need to start that transition 10 years before that. This means you will forego the market growth potential for almost 20 years. I would try to discourage this, but ultimately you the investor and retiree will have the final say.
On the other extreme – if your retirement date is flexible and your risk tolerance is high, you don’t need to reposition your portfolio until the day before retirement. For such a person, even if the market crashed the day before they retired, they could either push off their retirement, or just retire and accept the risks associated with such a retirement.
Those are two extremes. I would not prescribe either.
However, the method I describe below is a best practice for middle-of-the-road risk tolerance and a small degree of flexibility in their retirement date.
My prescribed transition period starts 5 years prior to retirement. When you enter the 5-year period before your retirement date, you should start transitioning your portfolio into income mode.
The transition will also be gradual, meaning you need not create your conservative with one re-allocation. You can achieve your income-mode allocation over the 5-year transition period.
The transitional re-allocation will happen once a year, meaning you don’t need to implement the gradual transition on a daily, weekly, or monthly basis. Just once a year, preferably at the beginning of the year is enough.
Let’s give an example:
- If your income-mode allocation requires 50% in bonds, and currently you have 0% in bonds, you should move 10% of your portfolio into bonds in each of the 5 years prior to retirement. If you move 10% into bonds for each of the 5 years, you will end up achieving your 50% bond-allocation by your date of retirement. The 10% move should be made at the start of each of the 5 years.
- If your income-mode allocation requires 30% in bonds, and currently you have 10% in bonds, you should move 20% more of your portfolio into bonds over the 5 years prior to retirement. 20% over 5 years = 4% per year for each of the 5 years. By doing so, you will end up achieving your 30% bond-allocation by your date of retirement. Again, the 4% move should be made at the start of each of the 5 years.
This method is based upon historical performance dating back to 1926. That history includes the great depression, the great recession, WWII, and other major events. See this chart for the details:
S&P 500 Holding Periods (1926-2019)
88% of 5 year market performances will end positive. (11/90 = 12% of 5-year periods end with a loss. 88% end with a gain, and the average 5-year performance ends with a handsome 11.82% annual return)
Now, of course I recognize that some 5-year intervals don’t end positive. (That’s why I acknowledged above that a risk-averse investor with no flexibility on retirement date may want to take a different approach – sometimes too much knowledge can be self-defeating.) But my prescribed method is a balanced approach for most investors, and this is how I guide my clients, too.
If you are getting “paralysis by analysis” with all this, you would benefit from having an asset manager taking care of it for you. This is something my firm specializes in, especially for Federal employees. You can request a complementary consultation below.