How to Build a Retirement Portfolio That Will Stand Up Over Time

Dana Anspach

July 28, 2020

When working and saving, typically you invest your retirement portfolio in a way that gives it the potential to earn the highest returns possible while planning to ride out any big market downturns.

Once retired, the goal changes. A different goal means a different portfolio. A retirement portfolio needs to produce reliable cash flows that last the rest of your life regardless of the variety of market conditions that occur over your retirement years. Rather than controlling the volatility of the account values, you need to manage the volatility of the income stream so it is as consistent as possible.

In other words, you need a retirement portfolio that remains standing under all conditions. There are four primary ways you can construct such portfolios.

1. 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 composed of 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 9.1% for a 60% stock/40% bond portfolio from 1926 – 2020).

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 much to your outcome if your holding period is seven years or more.

Is 60/40 the best retirement portfolio allocation? Not necessarily, but it is used as an industry standard. When you use T. Rowe Price’s allocation tool (it’s free but registration is required), 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 the next question to ask is, “What should the underlying stock mix look like?” If you follow Dimensional Fund’s work and start with an allocation that approximates what they use in their 60/40 balanced fund, it would look like this:

60% Total Weight to Equities

  • 18% US Large Cap Value
  • 6%  US Large Cap Growth
  • 9%  Small Cap Value
  • 3%  Small Cap Growth
  • 6%  Real Estate
  • 6%  Developed Large Cap Value
  • 5%  Developed Small Cap Value
  • 2%  Developed Small Cap Growth
  • 5%  Emerging Markets

40% Total Weight to Bonds

  • 10% One-Year Bonds
  • 10% Two-Year Global Bonds
  • 10% Five-Year Bonds
  • 10% Five-Year Global Bonds

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

2. Guarantee the Outcome

If you want something that is 100% guaranteed, give up the idea of a traditional portfolio. Instead 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 investments have 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 the book Control Your Retirement Destiny offers a comprehensive look at each annuity type and how and when it may make sense for you. (Disclosure – I am the author of this book and the Founder & CEO of Sensible Money – we sell no annuity products.)

3. 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 isn’t easy. For example, CDs that used to pay 5% – 6% are now paying 1.5% – 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. (For example, this occurred 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.

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4. Time Segmentation

The time segmentation approach to building a portfolio for retirement involves choosing investments based on the point when 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. In general, 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’ as a railroad track.

The track is laid by creating 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 ensure fixed cash flow sources provide the first 5-10 years of your retirement expenses. This process is referred to as “asset-liability matching” and has been used by pension plans for many years.

First, 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. Think of this as your runway into retirement. Your financial plan, as well as your risk tolerance and time horizon, are all factors to consider to determine the length of the track to be laid.

Next, the portion of your portfolio not used to create the income ladder is invested for upside (potential growth). You can use the Total Return philosophy (described earlier in this article) for this portion of your portfolio. You must make sure you have exposure to multiple equity asset classes.

Now, you manage it. Each year you decide if additional track should be laid. Harvest the growth portion of your portfolio when it has met or exceeded its target value. The target value is a projection of the minimum amount you need to have each year for your plan to work through life. For example, if you’ve calculated that you must have $1M left by age 70, and that year you have $1.2M, you sell $200,000 of gains and use the proceeds to lay additional years of railroad track (to buy bonds that mature on the tail end of your income ladder).

There is no such thing as a perfect retirement portfolio, but this last approach is, in our opinion, as close as you can get. It helps you keep a long-term focus during volatile markets. And the objective of this structure is to keep the cash flow consistent.

The portfolio approach that is best for your situation may be a combination of the strategies outlined above. It is best to use a comprehensive retirement income plan to project your future withdrawal needs and then engineer a retirement portfolio that aligns with those goals.

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