Should My Investment Allocation Become More Conservative in Retirement?

Written by: Harmony Wagner, CFP®

Retirement is one of the biggest financial transitions for many people, and one that often leaves people wondering if they should become more conservative with their investment allocation. Going through this type of significant life transition can make people feel like they must make a major corresponding adjustment in their investment strategy. As soon-to-be retirees approach their final day of work, I often hear this question asked by clients, friends, and family members: “Should I become more conservative in retirement?”

In this article, I will discuss:

• Why Retirees Feel Pressure to Become Conservative
• What the Data Shows about Retirement Investment Strategy
• How to Navigate Risk Tolerance in Retirement

 

Why Retirees Feel Pressure to Become Conservative

The concept of becoming “more conservative” typically refers to reducing exposure to the equities market. Conventional sentiment dictates that a retired person should be more conservative than someone who is still working, and many retirees may have seen their parents or older family members take this approach to risk tolerance in retirement. The idea stems from a place of risk aversion.

As retirees make the switch from saving into their portfolios to drawing down on their assets, the risk of market volatility may seem scarier and more severe than it did when they were not relying on their portfolios for distributions. The desire to avoid the risk of volatility is what drives many people to choose to invest more conservatively. Many soon-to-be retirees feel that they are being safe or prudent by adjusting their risk tolerance to be more conservative in retirement. However, instead of basing such an important decision on what might “feel” comfortable, let’s take a look at what the data reveals about retirement strategy.

 

What Does the Data Show About Retirement Investment Strategy?

An individual who exits the workforce at age 65 can reasonably expect to live 25-30 years in retirement. In order to have enough growth to sustain one’s lifestyle for multiple decades, it is important to be invested in the asset classes that provide the best growth over the long term. Historically, the best-performing asset class has been the stock market.

From 1950 through 2020, the average annual return of the stock market has been 11.4%, while bonds have been up an average of 5.9% annually over the same time frame. Cash of course, remains flat. Given the track record for equities compared to bonds and cash, it should not be a surprise that maintaining adequate equity exposure creates the most successful retirement story.

There have been a number of studies done over the last few decades that look at historical periods of returns and test different portfolios to see what types of allocations work best. These studies compare a portfolio that becomes more conservative (a declining equity path), a portfolio that remains static, and a portfolio that becomes more aggressive (rising equity path) throughout the hypothetical retirement period. A study performed by Kitces and Pfau in 2014 found that a portfolio that became more aggressive throughout retirement was actually the best strategy, regardless of the market trajectory during that time.

Essentially all potential market scenarios in retirement boil down to four basic trajectories.

1. The market starts strong and remains good
2. The market struggles early and remains poor
3. The market starts strong early on but later drops
4. The market struggles early but later recovers

 

In both scenarios 1 and 2, investment allocation does not matter as much. If the markets are always on the up; everyone wins regardless, although a higher equity allocation will result in a higher portfolio balance at the end. If the markets are down throughout all of retirement, the odds of sustaining any portfolio allocation through a long retirement would be slim to none.  However, neither of these two scenarios are likely over a long timeframe, because as every investor knows, market behavior is not perfectly linear. It is much more likely that a retiree encounters either scenario 3 or 4.

In scenario 3, the market starts strong early on but later takes a turn for the worse. In this case, having an increasing allocation to equities in the good years generates enough growth to sustain the portfolio throughout the challenges of the latter. In scenario 4, as the market drops early on, an increasing equity allocation means that the investor is continually buying into the market at discounted prices, and when their portfolio recovers down the road, it is the explosive growth in equities that compensates for the tough early years. In either case, the importance of equities cannot be overstated.

 

How to Navigate Risk Tolerance in Retirement

The risk tolerance decision is more complex than looking at hard data and making an analytical determination. For many people, financial decisions are emotional and the fear of being imprudent or taking on unnecessary risk can be crippling. For those investors, it can be helpful to look at the risk landscape in a broader view to avoid fixating only on market volatility without considering other factors.

Imagine you were planning on going camping in the Adirondacks, and you became so hyper-focused on the risk of getting a sunburn that you failed to take the proper precautions to avoid bear attacks. Both sunburn and bear encounters are real risks when in the Adirondacks, but obviously one of those scenarios would be far more devastating than the other. This example is somewhat oversimplified, but the retirement risk landscape is similar. There are multiple risks at play, and some have more potential to be catastrophic than others.

The risk of market volatility is real; in fact, it’s almost certain that over a multi-decade time span, there would be not just one, but several significant corrections. However, for investors who are mentally and financially prepared to stay the course throughout market downturns, a bear market is not likely to lead to financial calamity. On the other hand, if an overly cautious investor chooses to combat volatility risk by keeping too much of their portfolio in fixed income or cash, that individual becomes exposed to the risk of depleting their retirement assets by not achieving enough growth to sustain them over 20-30 years. Running out of money in the later years of retirement would almost certainly be devastating and very difficult to recover from.

There are ways to protect oneself in retirement without becoming overly conservative in your portfolio. For example, every investor, whether retired or not, should maintain an adequate emergency reserve fund in the bank and should have a plan for handling any needed portfolio distributions. It’s also important that the equities portion of your portfolio is well-diversified and monitored according to the ever-changing market and economic conditions.

 

Conclusion

Ultimately, an investor’s retirement allocation should accomplish two important objectives: setting him or her up for long-term financial sustainability and providing peace of mind. While there are ways to help protect against potential risks in retirement, shifting to an overly conservative asset allocation is not typically prudent because that strategy ignores a major risk–the risk that without sufficient growth, a portfolio may fail to last to the end of retirement. Working with a trusted financial advisor can help give retirees the confidence they need to maintain an appropriate exposure to equities and sustain a long and happy retirement. If you have any questions regarding risk tolerance in retirement, please feel free to contact our team for a discussion.

 

You might also be interested in our recent articles:

• Inflation: Why is this such a big deal and how does it affect me?
• Planning for Retirement – 5 Factors to Consider Beyond Your Finances

 

Bouchey Financial Group has offices in Saratoga Springs and Troy, NY.