How should my investment strategy change in retirement?

If you've been reading this blog for a while, then you know my approach to investing: determine your risk tolerance and capacity, design a portfolio of uncorrelated asset classes which matches them, and then optimize based on factors of increased returns and other incremental improvements.

That's all well and good, but -- what about retirement? Aren't you supposed to invest more conservatively? Isn't your investment management strategy supposed to change at that point? Good question.

Back to basics

One of the very, very fundamental ideas of investing is this: always invest to your time horizon. If you don't need the money for another 20 years, you can generally afford some ups and downs. If you need the money next year, even investing in a well-diversified equity (stock) portfolio is a pretty dangerous gamble; you'd be better off having the money in cash. This is such an important tenet that fiduciaries can literally get sued for not following it!

Intuitively, then, it makes sense that you'd be more conservative with your retirement savings as you get closer to retirement. After all, retirement is your goal, so as it gets closer, your time horizon gets shorter, right?

Well...not really. At least, not appreciably. After all, your retirement savings aren't for your first month of retirement, or even your first year -- they're for the rest of your life. And I don't know about you, but I'm not planning to kick the bucket the second I stop working.

So assuming that you're you're likely to live through at least 90, your time horizon at 30 is 60 years. If you retire at 60, your time horizon is 30 years...still well beyond the point where a conservative portfolio is mandated.

But what about the bucket approach?

In response to this, some of you are probably (and cleverly) thinking of some version of the "bucket approach". After all, while the time horizon for the end of retirement is 30 years when I'm 60, the time horizon for my first year of retirement is right now! So: what if you divided your portfolio into buckets?

The idea might work something like this: you have one part of your portfolio that's for the next 2-3 years. It's in mostly (if not all) cash. Then there's the part that something like years 4-10 -- mostly bonds. And then there's the equity part of your portfolio for years 10 on. Pretty neatly matches the time horizons, doesn't it?

This is true...but there's an issue. What happens when you start spending down that cash? By the time you're 67 or 68, your cash bucket will be gone! So the buckets will require some amount of maintenance, such as using bond interest to refill cash, stock gains and dividends to refill bonds, etc.

That still forms an elegant mental image, though, doesn't it? A "waterfall" of self-filling buckets that pour into each other over time, a perpetual-motion portfolio. So appealing, in fact, that it's used by many financial advisors, and is often a point of discussion by the smart folks at Morningstar.

And yes, there's a "but" coming. The "but" is simply this: research shows that bucket strategies are generally less effective than the asset allocation-based approach I outlined at the beginning of this article. (Google "Kitces bucket strategy" for a bunch of research on the topic, or check out Woerhide and Engle's paper.)

Why? It's fairly straightforward: the bucket strategy entails holding so much cash that the overall portfolio returns are significantly reduced. Low returns = worse Monte Carlo outcomes = worse retirement. Sure, there's reduced overall volatility...just not enough to make up for the reduced returns.

More conservative != more better

And therein lies the wrinkle in many other strategies that go more conservative as retirement approaches -- and there are many of them. Jack Bogle himself suggested that your stock allocation should be 100% minus your age. And Target Retirement Date funds set themselves on a "glide path", starting fairly aggressive and getting more conservative as the retirement date in question approaches.

And honestly? I don't blame them. Back during the 07-08 downturn, the media was aflame with outraged holders of target retirement funds who, despite being in retirement, lost over 20% their portfolio, indicating that they probably had a ~40% allocation to stocks. Now, any financial advisor would consider such a portfolio to be entirely reasonable for most retirees, but clearly many people haven't internalized the whole long-time-horizon thing we just talked about.

(Side note: I often run Monte Carlo simulations to determine if a more conservative portfolio would help a given client in the event of a bear market at retirement. To date, a more conservative portfolio has almost always reduced the success rate. Why? Those pesky lower returns!)

Now, the prospect of losing even 20% of your holdings in a given year of retirement is scary, and I get that. So I can see the appeal of an almost-all-bond portfolio, or a portfolio that allows you to live off the interest and dividends, or what-have-you. But all of these strategies take money off the table, money that you could be using to "live your best life", as the kids say these days.

Think about it in terms of a "safe withdrawal rate" -- the amount you could withdraw from your portfolio over your lifetime and keep the Monte Carlo success rate at around 80-90%. Sure, you could have an all-bond portfolio, but the lack of returns would drastically lower your safe withdrawal rate compared to a 50/50 portfolio -- and remember, "safe withdrawal rate" takes volatility into account! You could live off the interest and dividends of your portfolio, but then congratulations -- you die sitting on a ton of money that you never touched, but could have. And you could take out an annuity, but again, the fees and/or low annuitization rate will most often eat into your returns such that your safe withdrawal rate is lower than it would be if you'd just invested the money.

So...how should my investment strategy change?

We've gone through a number of things not to do -- the retirement bucket approach, automatically going more conservative in retirement, etc. So what's the answer? Perhaps unsurprisingly, it's this: your strategy shouldn't change. Or rather, it shouldn't change simply because you're approaching retirement. Monte Carlo is Monte Carlo; if circumstances gradually change such that a more conservative portfolio makes sense, due to income/expenses/current portfolio/etc., then do that. Heck, there's a case to be made for going more aggressive in retirement, at least after the first few years when a bear market won't completely wreck your projections.

(To be clear: you should always have a Plan B for the case where a bear market comes along during your retirement year. It might include working another year, or moving to semi-retirement rather than full retirement, or taking out a reverse mortgage, but there should always be a plan in place for if the dice come up snake eyes.)

This is why I love Adaptive Financial Planning -- by its very nature, it takes events such as retirement into account, allowing you to adapt accordingly without having to change the fundamentals of your strategy!

Now, as I mentioned before, this is all easy for me to say, but when you're near (or in!) retirement yourself, it's tough to rely on theory alone. So if you have any thoughts or questions, feel free to leave a comment or send me an e-mail!

Britton is an engineer-turned-financial-planner in Austin, Texas. As such, he shies away from suits and commissions, and instead tends towards blue jeans, data-driven analysis, and a fee-only approach to financial planning.