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Asset Allocation for Retirement Portfolios

When making regular purchases of an investment (i.e., dollar cost averaging into it), volatility tends to reduce the average price of shares purchased. When dollar cost averaging out of an investment, volatility does the same thing–it reduces average share price.

Of course, when you’re on the selling side, reducing the average price per share is not a good thing. As a result, any asset allocation method for a portfolio in its distribution phase must either:

  • Accept the fact that volatility will probably be harmful to returns, or
  • Make an effort to temper the volatility.

Which Volatility to Reduce

If your portfolio consists entirely of an S&P 500 index fund, and you’re selling shares each day to fund living expenses, the volatility you’d be concerned with is the daily volatility of the S&P 500. If you’re selling once per month, you’d be concerned with month-to-month volatility. If you place one sell order each year, it would be annual volatility that concerns you.

In other words, the volatility that matters is the volatility of the investment(s) you’re selling over periods of time equal to the frequency with which you’re selling. And, therefore, it’s likely beneficial to make efforts to set your selling frequency equal to periods over which the investment(s) you’re selling has historically had the lowest volatility.

When DCA’ing out of stocks, this suggests that reducing the frequency of your sell orders as much as possible is likely to be beneficial (because volatility of stock returns is inversely related to the length of the period of time considered).

The “Buckets Method” of Asset Allocation

I’ve written before about the “bucket method” of asset allocation in retirement. It typically consists of setting up the following three “buckets” (or something similar):

  • 2 years of living expenses kept in a money market account,
  • 3 years of living expenses kept in short-term bond funds,
  • The remainder of the portfolio uses a static allocation (often near 40/60 stock/bond).

Then the portfolio is rebalanced annually, making sure to fill the first and second buckets back up each time.

The problem is that this method still leaves an investor with the return-damaging effects of DCA’ing out of volatile investments, because the annual rebalancing will amount to annual selling of stocks and/or long-term bonds in order to refill the first two buckets. In other words, even though the investor is spending out of the money market, he’s still funding the money market with regular, frequent sales of stock.

Minimizing Volatility

Jim Otar, however, offers a slightly different method in his Unveiling the Retirement Myth–a method which makes an effort to minimize the return-damaging effects of volatility while selling.

Otar suggests the following rules are followed:

  1. Living expenses are paid for out of the money market bucket, then (if that is depleted) out of short-term bonds.
  2. When the portfolio receives a cash inflow (dividends, interest, tax refund, etc.), first top off the money market bucket (up to 2 years again), then top off the short-term bonds (up to 3 years again), then invest any remainder in equities or long-term bonds.
  3. If rebalancing from equities to fixed income, first use the cash to top off the money market bucket, then top off the short-term bonds bucket, then purchase long-term bonds with any remaining money.
  4. If rebalancing from fixed income to equities, first use the cash to top off the money market bucket, then top off the short-term bonds bucket, then purchase equities with any remaining money.
  5. Keep rebalancing of the 3rd bucket (the one made up of equities and long-term bonds) to a minimum. Otar suggests once every 4 years.

The idea is to do everything possible to reduce the frequency with which stocks are sold–by keeping enough cash to fund living expenses and by keeping rebalancing to a minimum.

Sounds like a reasonable approach to me.

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Comments

  1. Very interesting. A lot of questions here (please answer whichever you can; I don’t mean to keep you writing all day):

    – “Keep rebalancing of the 3rd bucket (the one made up of equities and long-term bonds) to a minimum. Otar suggests once every 4 years.” Does it matter if the portfolio is in a taxable vs. tax-favored account?
    – What if balances in the 3rd bucket vary greatly over the 4 years from your 40s/60b target allocation?
    – Otar’s suggestion more specifically is that you rebalance after presidential elections. Do you agree with his reasoning here?
    – Is there a point beyond which having 2 years cash/3 years s-t bonds could be detrimental to the growth of the portfolio?
    – Overall, should this strategy be followed when you’re close to retirement or only after the retirement point? Does it make any difference if you’re annuitizing part of your assets?

    Thanks!

  2. As always, I don’t have all the answers, but here are my first thoughts:

    Does it matter if the portfolio is in a taxable vs. tax-favored account?

    Doubtful. It’s often suggested that taxable accounts should be rebalanced less frequently than tax-sheltered accounts. But every 4 years is already quite infrequent (in my opinion, at least).

    What if balances in the 3rd bucket vary greatly over the 4 years from your 40s/60b target allocation?

    I’d be surprised if that didn’t happen, honestly. To me, Otar’s strategy is somewhat of a tradeoff. He gives up the consistent “risk profile” that’s achieved with annual rebalancing. In exchange, he minimizes the negative effects of DCA’ing out of a volatile investment.

    Is there a point beyond which having 2 years cash/3 years s-t bonds could be detrimental to the growth of the portfolio?

    I’m not entirely certain what you’re asking here. Are you speaking to a point at which the portfolio becomes a certain size (either on the high end or low end), a point at which the investor reaches a certain age, or something else entirely?

    Should this strategy be followed when you’re close to retirement or only after the retirement point?

    I’d generally be inclined to say that there’s no need for so much in cash and ST bonds prior to retirement. That said, others might disagree. Also, there’s the question of whether buckets #1 and 2 should be created gradually or all at once upon retirement.

    Does it make any difference if you’re annuitizing part of your assets?

    Well, the above discussion assumes that the portfolio is a distribution portfolio. As long as that’s the case, I’d argue the answer is no. If, however, an investor owns an annuity large enough to completely fund his or her living expenses, the remaining portfolio would be an accumulation portfolio…in which case the above strategy wouldn’t make much sense.

  3. @me: “Is there a point beyond which having 2 years cash/3 years s-t bonds could be detrimental to the growth of the portfolio?”

    @Mike: “I’m not entirely certain what you’re asking here. Are you speaking to a point at which the portfolio becomes a certain size (either on the high end or low end), a point at which the investor reaches a certain age, or something else entirely?”

    I was probably muddled (not unusual with me). I guess I was going on a gut feeling that this seems like a lot to have in cash, which is unlikely to earn much and could lose considerably to inflation – vs. stocks or bonds that have more potential for growth. But it’s hard during one’s working years to reconfigure one’s thinking to what’s going to happen in retirement when there are no longer any wages. Why the recommendations for 2 cash + 3 stb specifically? I suppose this comment – “Also, there’s the question of whether buckets #1 and 2 should be created gradually or all at once upon retirement” – has some effect on the situation too.

  4. It is indeed a lot of cash. My understanding is that the reasoning is something like this:

    If you’re going to spend the money in the next two years, cash/money market/etc is the only thing that makes sense. Hence, once you’re in retirement, 2 years of living expenses should be kept in cash at all times.

    If you’re going to spend the money 3-5 years from now, short-term gov’t bonds are likely the best fit. So keep 3 years of expenses (for years 3, 4, and 5) in such bonds.

    The remainder of the portfolio is for funding years 6 and beyond.

  5. Good points in times like these where the market is going up and down Dollar cost averaging can really pay off.
    When selling sell into strength. It is very hard to guess a top but when the market is trading at 18 month highs I think it is time to take a little off of the table.

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