As you near retirement, your approach to investing typically needs to change. While online retirement calculators might project that you have more than enough money to last the rest of your life, there’s an important and often overlooked risk that can change that calculation. If you’re in your 30s and your portfolio declines by 30% during a severe bear market, you still have plenty of time to recoup those losses. If you have liquid capital, you could even invest more at the market lows and generate greater long-term gains. But if you’re 60 and on the brink of retirement, a 30% selloff could significantly alter your long-term results, potentially reducing your income and limiting your retirement flexibility.
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For these reasons, these would be some smart moves when you are 1-5 years away from retirement. As always, best to check with your own financial adviser before making any moves.
A diversified portfolio
Adjusting a portfolio as you near retirement doesn’t mean you should sell everything and stay in cash. Your retirement may last 25 to 30 years or even longer, so you’ll have to protect your portfolio against inflation and diminishing purchase power. For these reasons, you’ll still need exposure to growth investments, like stocks. The key is striking the right balance between growth and safety, and the calculus is much different than it was when you were 30 years old.
As you near retirement, sequence-of-returns risk becomes more important. While that may sound like a technical term, it’s easy to break down.
Sequence-of-returns risk simply refers to the additional risk older investors face due to their shorter investment time horizons, when there is less time to recover from losses. When investors are 30 years old, they can usually afford to ride out a 30% decline in the stock market, as over time markets have historically recovered and gone on to reach new highs. But if you’re 65 years old, a 30% market decline could significantly reduce your income and quality-of-life in retirement.
For this reason, it’s usually prudent to draw down your percentage of equity investments in retirement – but not to the point that your portfolio can’t at least keep up with the rate of inflation.
High-quality bonds
The best way to earn more than a savings account while reducing the volatility of an equity portfolio is to own high-quality bonds. Bonds serve as the ballast in a retirement portfolio. They often go up in value when stock markets decline, helping to smooth out the ups and downs. Even when bonds and stocks move in the same direction, bonds typically fluctuate less dramatically, helping to reduce overall volatility.
Bonds also pay interest. This makes them appealing to many retirees living off fixed incomes. But the main purpose of bonds for those 1-5 years from retirement is to provide stability and reliability.
A larger-than-usual emergency fund
To help counter sequence-of-returns risk, it’s a good idea for pre-retirees to keep a larger-than-usual emergency fund as well.
It may feel counterintuitive to increase the lowest-returning portion of your asset portfolio, but a big emergency fund plays an essential role in protecting retirement plans.
Cash serves three primary purposes in a pre-retirement portfolio:
- It allows investors to take advantage of market declines
- It reduces the risk and volatility of a portfolio
- It protects investors from selling investments when they are down
For these reasons, many financial planners suggest maintaining approximately one to two years of expected withdrawals in highly liquid assets such as high-yield savings accounts, money market funds, CDs or short-term Treasury bills.
This cash reserve can reduce anxiety during market volatility and help investors stick to their long-term strategy.
Income-producing investments
Retirees generally draw more income from their portfolios than younger investors do. But picking the right income-producing investments requires an analysis of risk and reward. Dividend-paying stocks and funds can be good options if you’re looking for both growth and income. But they fluctuate in value more than most bonds, and you’ll usually earn less income as well. That’s the price you pay for a hybrid investment.
Annuities can be a good choice if you’re looking for guaranteed, defined payouts. But they may carry higher fees and have reduced liquidity.
The important thing to remember is that no single investment needs to meet all income needs. The typical retiree draws income from a variety of sources, such as Social Security and retirement accounts, in addition to ordinary dividends and interest.
A few things to note
When it comes to investing, especially right before retirement, simple strategies often work well.
Approaching retirement, portfolios generally need to change. However, the typical shift towards asset protection should not come at the cost of long-term capital appreciation. A balance between both of these needs is often the most appropriate option.
This can come in the form of a diversified portfolio of stock funds, high-quality bonds, and adequate cash reserves. While not appropriate for every single investor, this type of portfolio can provide structure while still allowing for growth.
