How to ‘De-risk’ Your Retirement Portfolio So it Doesn’t Take a Big Plunge
Anybody who has lived in a cold climate knows what de-icing a car is like. If you’ve ever deiced a car you’ll get a chuckle out of this story, and see how you can apply it to de-risking your retirement money.
When I lived in Colorado I was in a hurry one morning and scraped only a small peephole in the ice on my windshield. I made it about a mile down the road when an officer pulled me over. He poked his head in my car and with an exaggerated slow twist at the neck he made an attempt to peer out the front windshield. Then he turned and stared at me. All I could do was shrug my shoulders, smile and say, “I was in a hurry.”
Amazingly enough, he didn’t give me a ticket. He did make me sit there until all the ice had melted off. I understand. I made a bad choice about risk and return. Driving with an ice covered windshield isn’t smart. Being in a hurry doesn’t make it a wiser thing to do.
Lately, I’ve heard a word floating around that reminded me of this experience: De-risk. Like de-icing a car, you can de-risk your portfolio when the risk-return trade-off for continued risk taking no longer makes sense. Unfortunately, unlike the visible signs of an iced windshield, it takes analysis to know when it is time to de-risk your retirement portfolio. And de-risking is important. It helps insulate your future retirement income from a market plunge that could occur near or soon after your retirement date.
There are two approaches to de-risking that you ought to consider.
The traditional modern portfolio theory approach
The traditional approach to investing is to build a model portfolio that is designed to achieve the most potential return for the least potential risk. Risk is typically measured by short term volatility such as “this portfolio could be down as much as 30% in a single calendar quarter.” This is usually coupled with a statement like, “but over the long term, this portfolio should have a higher return than this other portfolio that would have less volatility.”
When you de-risk using this approach you rebalance when something gets out of a tolerance range. For example, suppose you determined you should have 60% of your retirement money in equities and 40% in bonds. After a year of strong equity returns, you may find your allocation drifted to 65% equities, 35% bonds. If you had determined ahead of time that your equity allocation could drift from 57% to 63%, at 65% you would now be out of your tolerance range and you would rebalance back to 60/40 by selling 5% of your equity holdings and buying bonds.
This approach to de-risking retirement money is an industry standard and it is effective at managing risk as measured in the form of short-term volatility. But what does it have to do with your retirement income goals? Not much. Contrast the traditional approach with a planning-based approach.
A planning-based approach
Something that makes a little more sense to me is a planning process that tells you when to de-risk your retirement money based on your goals. For example, suppose you create a financial projection at age 50 and it shows you year-by-year approximately where your account values need to be in order for you to achieve a specific retirement income at a defined point in the future. Each year you measure your retirement portfolio against your plan.
After a year or two of strong equity returns, you might find your account values are ahead of target. Now you can de-risk your retirement money by taking the excess gains and locking in your first year or two of retirement income by buying a safe investment like a CD, agency bond, or fixed annuity that will mature in the year you plan to retire. The planning-based approach tells you when de-risking makes sense by measuring against what it is that you want to achieve, and by considering the point in time where you will need to use the money.
With this approach to de-risking, the allocation of your retirement money as measured in terms of stocks versus bonds may drift across a wider range than with the traditional approach. But maybe that’s OK. After all, if retirement is far away, does it matter what your portfolio did this past calendar quarter? And if it is retirement money you need next year, it shouldn’t be exposed to any downside risk. The gray area is the money you might need in two to 10 years. A planning-based approach can tell you whether the gray area should or should not be exposed to risk by measuring the potential outcomes against something that matters — your goals.
Which form of de-risking your retirement portfolio is best? Either one is better than not de-risking at all! And both are far superior to my illogical attempt in Colorado to take on additional risk in order to make up for lost time.
My personal preference is approach number two — something based on your goals and your plan. As it stands here in the middle of 2017, we have been doing quite a bit of de-risking, as the equity returns have been strong. If you’re near retirement and haven’t put a risk management plan in place for your retirement money, it’s time to get started.
This article was originally printed on MarketWatch.