How to Build a Retirement Portfolio

Strategy BlogA portfolio is a mix of investments that you put together in an intentional way to accomplish a goal. When working and saving, the goal is to earn as high a rate of return as you can while not taking so much risk that it will scare you into pulling out of the market during a downturn.

Once retired, the goal changes. Different goal = different portfolio. A retirement portfolio needs to produce reliable cash flow that is projected to last the rest of your life regardless of the variety of market conditions that may occur over your retirement years. There are four primary ways you can construct retirement portfolios, and of course, numerous variations of each.

Total Return

With a total return retirement portfolio, you pick a mix of stock and bond index funds (or individual stocks and bonds) that you expect will deliver your desired average return over time. For example, you might look at the historical returns of a portfolio that is about 60% equity index funds and 40% bond funds and conclude that you expect to earn an average return of about 7% a year. Based on the 4% withdrawal rule, you might estimate you could withdraw 4% a year and continue to watch your portfolio grow. You would withdraw 4% of the starting portfolio value each year regardless of the actual account performance that year. (Note Vanguard’s model portfolio allocations show a gross average annual return of 8.7% for a 60% stock/40% bond portfolio from 1926 – 2016).

This type of withdrawal plan is referred to as “systematic withdrawals.” When using this approach, the growth portion of your portfolio should consist of multiple equity asset classes including U.S large cap growth and value, U.S. mid cap growth and value, U.S. small cap growth and value, international large-cap, international small cap, emerging markets, and depending on the time frame of the portfolio sometimes real estate and commodities. Adding real estate and commodities may help reduce the one-year volatility of a portfolio, but may not contribute as much to your outcome if your holding period is seven years or more.

Is 60/40 the right retirement portfolio allocation? When you use T. Rowe Price’s allocation tool, choose “retirement” as your goal and a birth year of 1950, the model portfolio mix that comes out is 5-15% in short-term investments (like cash or money market), 25-35% in bonds, and 50 – 65% in stocks.

These tools are great, but what should the underlying stock mix look like? We follow Dimensional Fund’s work, and start with an allocation that matches about what they use in their 60/40 balanced fund, which looks like this:


For the bond portion of the portfolio, in a rising interest rate environment, we like funds with a low duration, or even better, individual bonds or Guggenheim Bulletshares.

Guarantee the Outcome

For a retirement portfolio that is 100% guaranteed, use government bonds and annuity products (immediate annuities, fixed annuities, equity index annuities, variable annuities with income riders, and longevity insurance or a QLAC – which is a form of a deferred immediate annuity.)

With this approach, you have no downside risk, but your income may not keep pace with inflation, and your portfolio has little-to-no ability to grow. When you guarantee the outcome, you are shifting the risk, so it costs more capital per $1,000 of desired cash flow than other approaches that have more potential for return (but also more risk). In addition, you are creating an inflexible strategy. What if due to a life-threatening health event you want to splurge on a once-in-a-lifetime vacation? You may not have access to your principal. Certain outcomes lock up your capital, making it difficult to change course as life happens.

Chapter 8 of my book Control Your Retirement Destiny offers a comprehensive look at each annuity type and how and when it may make sense for you.

Interest Only

Some investors prefer to build a retirement portfolio of income producing investments and live off the interest and dividends. In a low-interest rate environment, this is difficult. For example, CDs that used to pay 5% – 6% are now paying 2% – 3%. If you abandon safe investments for high yield investments like high-dividend paying stocks, REITs, and oil & gas master limited partnerships, you then run the risk that the dividend may be reduced, which would immediately lead to a decrease in the principal value of the income-producing investment. This can happen suddenly, leaving little time to plan. (I saw this occur in 2008 and 2009.) In retirement, having your income cut in half isn’t too pleasant. For investors who like to do research and pick individual securities, and who are ok with having their cash flow vary from year-to-year, this approach can work well.

Time Segmentation or Bucketing

This time segmentation approach to building a portfolio for retirement involves choosing investments based on the point in time where you will need them. It is sometimes called a bucket or lockbox approach. If you want to dig deeper into this approach, read William F Sharpe’s 2007 paper, Lockbox Separation, hosted on the Stanford website. There are many variations of the time segmentation approach in terms of how many buckets you have and what time frames they are aligned to. There is no such thing as a perfect retirement portfolio, but we think this last approach is as close as you can get.

With our version of time segmentation, safe investments are used for the money you need to withdraw in approximately the first ten years of retirement, and riskier investments are used for the portion of your portfolio you won’t need to touch for years eleven and beyond.

In Mike Zwecher’s book, Retirement Portfolios, Theory Construction and Management, he refers to this as a “Track Layer”. Think of ‘track’ in terms of a railroad track.

This track is laid by creating what is called an income ladder composed of safe investments like CDs, agency bonds, municipal bonds, and corporate bond ETFs. Both the interest and principal of the bonds are used to meet spending needs. The goal is to make sure the next 5-10 years of your retirement expenses are backed by fixed sources of cash flow. This process is referred to as “asset-liability matching” and has been used by pension plans for many years.

We lay an initial section of track that helps smooth out the transition into retirement and reduce your exposure to any big downturns that may occur during your early retirement years. Your financial plan, as well as your risk tolerance, time horizon, and our discussions with you, are all used to determine the length of the track to be laid.

The portion of your portfolio not used to create the income ladder is invested for upside (potential growth). We use the Total Return philosophy for this portion of your portfolio with exposure to multiple equity asset classes.

Each year we decide if additional track should be laid. The growth portion of your portfolio is harvested when it has met or exceeded its target value, as measured against your plan. When it is harvested, gains are usually used to lay additional years of railroad track (to buy bonds that mature on the tail end of your income ladder).

The retirement portfolio that is best for your situation may be a combination of the strategies outlined above. We use a comprehensive holistic retirement income plan to project your future, which helps us engineer a retirement portfolio that fits your goals.