Author Topic: Stock/bond portfolio allocation in retirement and pre-retirement years  (Read 5593 times)

chschen

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Hello,

My husband and I are a few years away from financial independence (maybe 3-4 years). Currently, we have a target allocation of 70% stocks, 30% bonds, but we were wondering if we need to slowly increase the bond portion of our portfolio as we get closer to early retirement or when we are fully within our early retirement. What are all of you planning to do (or currently do, if you're already retired)? It may be pertinent that we're in our early 30s and could rejoin the workforce if we needed to. We don't have children yet, but we probably will have two.

Thanks in advance for your replies!

nereo

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Hi there

Short answer is that it's up to your own risk tolerances and what margins of safety you have built into your portfolio.  You already mentioned that you could rejoin the workforce if needed to, so that gives you a lot of freedom. If you have the flexibility of lowering your spending during down economic years that will help a lot too. A SWR of <4% is another.
With hopefully 50+ years of retirement ahead of you, I personally would want to keep a large chunk in stocks to maximize returns.  I'm always weary of suggesting a specific % of a portfolio in bonds, because it depends on the size of the portfolio.  Instead, I'd think of it in terms of how many years would your bonds last you
My plan is to start with ~5 years in fixed income & cash.  During down markets I'll draw from that bucket, and during bull markets I'll refill the bucket. 

I'm still ~10 years out though, so for me this is a thought exercise.  I'm curious to hear what other people recommend.  I might modify my own plan :-)

Badass by 41

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Instead, I'd think of it in terms of how many years would your bonds last you

Wow, this is a really interesting take on the cash portion of your Asset Allocation. Thanks for sharing.

nereo

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Instead, I'd think of it in terms of how many years would your bonds last you

Wow, this is a really interesting take on the cash portion of your Asset Allocation. Thanks for sharing.
Sure.  I mean, I have a knee-jerk reaction whenever anyone saying "you need 50% of your investment in bonds when you hit retirement"*.  Well, how long are you planning on being retired for?  how big is your 'stach and how much are your annual expenses?  If you have $1M, spend $25k/yr and plan to live for another 50 years,  I think it's ludicrous to have 50% (or $500k) in bonds.
Even really bad markets tend to last only 3 or 4 years.  Why would I keep 20 years worth in bonds and sacrifice future returns? Especially if I'm able to earn some income during down years and/or reduce my spending.

*50% is a commonly used figure for people entering retirement, but use whatever % you wish.  Count years, not a percentage.

chschen

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Instead, I'd think of it in terms of how many years would your bonds last you

Wow, this is a really interesting take on the cash portion of your Asset Allocation. Thanks for sharing.

I agree--thank you, that's very helpful advice. It's more in-line with my husband's thinking, which I was questioning. I told him I'd check in with the forums so that at least we weren't flying into this blind.

beltim

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Even really bad markets tend to last only 3 or 4 years.  Why would I keep 20 years worth in bonds and sacrifice future returns? Especially if I'm able to earn some income during down years and/or reduce my spending.

*50% is a commonly used figure for people entering retirement, but use whatever % you wish.  Count years, not a percentage.

While I mostly agree with you, there are plenty of periods outside of the really bad times in the markets where bonds dramatically outperform stocks.  Bonds outperformed stocks during every single 1999-X and 2000-X period, every 2001-X except where X=2013, and 9 out of the last 13 rolling 5 year periods. 

brewer12345

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I bailed on the day job in January with DW and I age 40.  In the run to FIRE I had an aggressive portfolio.  Not so much in the equity percentage, since I take risk on the bond side when it is worth doing so, but highly concentrated in relatively few securities, not well diversified, volatile and weird (my largest position for a while was warrants in a company that did not yet exist as an operating entity).  As I approached my goal, I had research and work to do.  When I went poking around and looking at survivability of portfolios over a long draw period (40 years), equities of 50 to 70 percent seem to have the best survivability and you don't gain or lose much by being anywhere in the range as far as survivability goes (higher equities can give higher upside, though).  I sold down my big positions and diversified.  2/3 of the portfolio is in indexes, funds and stuff like CDs, cash and I bonds and the remaining individual picks are far more diversified than I was before.  I shoot for a total equity allocation of between 60 and 65% (63.x% now), with the balance in USD bonds, foreign currency bonds, merger arbitrage funds and CDs, etc.  I keep 1% of the portfolio for "swinging for the fence."  Allocations are different by account.  Taxable assets are 50% equity or less since this is money I am tapping sooner.  Tax deferred accounts are higher, with the 65+ funding at 80% equities.

nereo

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Even really bad markets tend to last only 3 or 4 years.  Why would I keep 20 years worth in bonds and sacrifice future returns? Especially if I'm able to earn some income during down years and/or reduce my spending.

*50% is a commonly used figure for people entering retirement, but use whatever % you wish.  Count years, not a percentage.

While I mostly agree with you, there are plenty of periods outside of the really bad times in the markets where bonds dramatically outperform stocks.  Bonds outperformed stocks during every single 1999-X and 2000-X period, every 2001-X except where X=2013, and 9 out of the last 13 rolling 5 year periods.

well... yes... but also no.  What's critical here is the time period you are concerned with. Let me explain.  Historically, equities have trumped bonds over all 20 year periods, and most 10 year periods.  The OP was asking about a portfolio with a 50+ year time line. Therefore, I'd advocate to have a large a percentage in an index fund as is prudent.

But, you bring a good point of that there are large periods when bonds have beaten stocks.  So let's take a look at why.  Looking back at the last 60 years, stocks have had years of +40.4% growth and -37% losses.  Comparing that to bonds, the first obvious question is "which bonds".  If we're looking at 10 yr US bonds* the spread is from -11 to +32%
What's peculiar is how a few very bad stock years have set up stocks to return less than bonds, particularly in the time frames you mentioned.  In the last 60 years, the SP has had a loosing year just 13 times, and has only lost 10% or more five times.  Three of those were whoppers: -37% (2008), -26.4% (1974) and -22.1% (2002).  On the other hand, the SP has recorded >10% gains 34 out of the last 60 years.
Predictably, bonds have been much less volatile, with fewer big loss decades but fewer big gain decades too. Not surprisingly, during the years when stocks recorded +10% gains the bond market almost always lagged behind.

All of which brings this back to how much in bonds one should have in their portfolio during retirement.  And it is a personal choice.  But personally, I want to have enough that I don't have to sell shares of my SP500 fund during these down periods, but leave the bulk of my assets where historically they do best over 10+ year time lines - in the stock market.  Since the index has returned to previous levels within 4 years in all previous years, that is my baseline. 

Abe

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Do most people invest in bond funds, or individual bonds? I know bond funds have lost a bit of value if one looks to sell off shares. If you rely on the dividends instead, is it essentially equivalent to owning individual bonds held for their entire term?

I ask because my parents will have about $1m in their 401k at retirement, about 75% in bond funds yielding about 3% currently. I am wondering if they should instead invest in bonds with 20-year terms that are yielding 3-4% (which they would be fine with, they have other sources of income coming). Assuming they diversify enough to mitigate risk of default, would this be a lower-cost way to ensure the 30-40k/yr by cutting out the funds' fees? I'm thinking that rates may stay steady in the long term and the issuers wouldn't be likely to call the bonds in order to re-finance. 

beltim

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All of which brings this back to how much in bonds one should have in their portfolio during retirement.  And it is a personal choice.  But personally, I want to have enough that I don't have to sell shares of my SP500 fund during these down periods, but leave the bulk of my assets where historically they do best over 10+ year time lines - in the stock market.  Since the index has returned to previous levels within 4 years in all previous years, that is my baseline.

Again, I mostly agree with you, but this is not accurate.  You only have to go back to the 2005-2008 period to find that over a 4 year period, the S&P 500 was down 20% over 4 years including dividends.

aj_yooper

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Re: Stock/bond portfolio allocation in retirement and pre-retirement years
« Reply #10 on: April 05, 2014, 01:01:06 AM »
Do most people invest in bond funds, or individual bonds? I know bond funds have lost a bit of value if one looks to sell off shares. If you rely on the dividends instead, is it essentially equivalent to owning individual bonds held for their entire term?

I ask because my parents will have about $1m in their 401k at retirement, about 75% in bond funds yielding about 3% currently. I am wondering if they should instead invest in bonds with 20-year terms that are yielding 3-4% (which they would be fine with, they have other sources of income coming). Assuming they diversify enough to mitigate risk of default, would this be a lower-cost way to ensure the 30-40k/yr by cutting out the funds' fees? I'm thinking that rates may stay steady in the long term and the issuers wouldn't be likely to call the bonds in order to re-finance.

In this case, they may be interested in building a bond ladder.  It can be a mix of terms so, if rates change, the portfolio can be adjusted to keep up with, my guess, higher interest rates eventually.  Additionally, having some equities in their holdings actually reduces the portfolio volatility, say 10 or 20%, 

nereo

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Re: Stock/bond portfolio allocation in retirement and pre-retirement years
« Reply #11 on: April 05, 2014, 06:10:56 AM »

Again, I mostly agree with you, but this is not accurate.  You only have to go back to the 2005-2008 period to find that over a 4 year period, the S&P 500 was down 20% over 4 years including dividends.
It all comes down to how you look at the time frames.
Perhaps we will have to agree to only mostly agree with one another :-)
As you said, from Jan 2005 to Dec 2008 the SP500 was -20.7% (~-5% annualized) with dividends.  But that included the second-worst year in the last 75 years. By the end of 2009 it was back in positive territory.   2005 & 2006 were actually were actually pretty good years for stocks (+10.1% and +13%), and '07 was essentially flat.
For the bond strategy I personally favor, what matters is how long it takes to recover from a market drop, not which rolling 3, 4 or 5 year periods ended up negative.  In the above time frame in 2005, 2006 & 2007 I'd only withdraw from equities, because the market was up or flat during those times.  When 2008 hit I'd start relying on the bond portion for my income.  Then, within 4 years the SP500 was back in positive territory again - time start to replenishing the bond portion while drawing down from stocks.  And this was through the worst stock market conditions since the great depression.  For every single historical period I have looked at this strategy plays out very well.

This plan obviously takes a bit prior planning and the dedication to stick to that plan.  Added flexibility makes it even simpler - on a huge market drop like 2008 I'd consider lowering my income by a few thousand and possibly finding some very part-time work (5-10hr per week, even low paying)  Both the OP seemed willing to do if necessary.

letro

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Re: Stock/bond portfolio allocation in retirement and pre-retirement years
« Reply #12 on: April 05, 2014, 06:34:10 AM »
http://news.morningstar.com/articlenet/article.aspx?id=608619
Take a look at the Bucket ideas at morning star by Christine Benz.
This article will allow you to use a spreadsheet to follow the bucket ideas from 2007 to 2012.
« Last Edit: April 05, 2014, 06:37:29 AM by letro »

nereo

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Re: Stock/bond portfolio allocation in retirement and pre-retirement years
« Reply #13 on: April 05, 2014, 06:38:16 AM »
http://news.morningstar.com/articlenet/article.aspx?id=608619
Take a look at the Bucket ideas at morning star by Christine Benz.
This article will allow you to use a spreadsheet to follow the bucket ideas from 2007 to 2012.
unfortunately, it's available only to members, of which I am not.  Any chance you can post the relevant parts?  I'd like to read it.
N

EDIT: nevermind, didn't realize it was a "free membership" option.
EDIT2: yes, that article describes a similar scenario, one where you draw on bonds only when the market drops, and you replenish the bond 'bucket' once the market recovers. IMO it gives the best of both worlds - it gives stability during the infrequent but gut-wrenching drops like 2008, '02 or '74, yet allows you to reap the long-term (multi-decade time frame) rewards of being mostly invested in stocks.
« Last Edit: April 05, 2014, 06:53:11 AM by nereo »

kyleaaa

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Re: Stock/bond portfolio allocation in retirement and pre-retirement years
« Reply #14 on: April 05, 2014, 07:39:39 AM »
There are many, many valid schools of thought on this. Personally, I plan to be around 60/40 when I retire and keep it there throughout retirement. Some people advocate going something like 80% into bonds at retirement and slowly ramping back up the equity exposure on the theory that losses in the first few years of retirement are much more costly than losses later in retirement. I might end up considering this approach because it has intuitive elegant appeal to me.

Or there may be brand new awesome theories by the time I retire. The best advice is to just play it by ear and stay flexible. Also, ignore the 4% SWR talk. That doesn't apply to you. 3% is the new 4%.
« Last Edit: April 05, 2014, 07:45:12 AM by kyleaaa »

nereo

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Re: Stock/bond portfolio allocation in retirement and pre-retirement years
« Reply #15 on: April 05, 2014, 10:23:51 AM »
There are many, many valid schools of thought on this.

Or there may be brand new awesome theories by the time I retire. The best advice is to just play it by ear and stay flexible. Also, ignore the 4% SWR talk. That doesn't apply to you. 3% is the new 4%.
Why is "3% the new 4%"? I don't understand what you mean by this - sure 3% SWR has an inherently higher level of safety, but with every scenerio I run 4% worked ~90% of the time, with no consideration to events like SS, side income or flexible spending.  Are you suggesting it wasn't a good idea from the start, or that you expect it not to work as well in the future?  I'm really just curious about what you mean.

Agreed - everyone has to do what makes them comfortable.  Personally, having 40% of my expected $800k portfolio in bonds would make me very uncomfortable due to how much I'd expect to trail the market over the next several decades. But many people value reduced volatility much more than I do.  To each their own.