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How to Craft a Successful Investment Plan In Retirement  Thumbnail

How to Craft a Successful Investment Plan In Retirement

Are you nearing retirement or already retired? Congratulations on reaching this major life milestone! But with this new chapter comes important decisions about how to manage your savings. One crucial aspect is selecting the right investment strategy to ensure your hard-earned nest egg supports you throughout your retirement years. 

Developing an effective retirement investment approach involves carefully considering factors. These include your target asset mix, investment choices, portfolio management, and tax strategy. With so many moving parts, building the optimal retirement portfolio may seem overwhelming. But don't stress - in this comprehensive guide, we'll break down the key steps to create a personalized investment strategy aligned with your unique retirement goals and circumstances.

KEY TAKEAWAYS

  • Selecting the right investment strategy in retirement is crucial for maintaining your financial well-being and quality of life.
  • Understanding your retirement cash flow needs and tax situation is the first step in developing an effective investment approach.
  • The time-segmented income buckets strategy helps align your investments with your short, medium, and long-term income needs.
  • Crafting a target asset allocation requires balancing growth and stability based on factors like risk tolerance, time horizon, and spending flexibility.
  • Implementing your portfolio with a mix of low-cost, tax-efficient index funds or ETFs can enhance returns and minimize costs.
  • Ongoing portfolio management, including regular rebalancing and tax-loss harvesting, is essential to maintain your investment strategy over time

WHY YOUR RETIREMENT INVESTMENT CHOICES ARE CRUCIAL

The investment strategy you employ in retirement will have an enormous impact on your financial well-being and overall quality of life. A good plan can give you the income and growth to fund your desired lifestyle. It can also help your portfolio handle market swings and reduce other key retirement risks like inflation and outliving your money.

On the flip side, a poorly designed investment plan can lead to a host of potential problems. You could face a gap between your income and expenses. You could take on too much risk. Or, you could be ill-equipped to recover from market downturns. Suboptimal investing choices can also result in paying more than necessary in fees and taxes, further eroding your hard-earned savings.

The stakes are magnified in retirement because, unlike in your working years, you'll generally be drawing down your investment accounts rather than adding to them. This means preserving your capital is paramount. With a shorter investment time horizon, your room for error is reduced and it becomes more challenging to recover from investment missteps. Your portfolio needs to be carefully calibrated to deliver reliable income streams that will last the rest of your life.

With so much riding on getting your retirement investment strategy right, it's worth investing the time and effort to set yourself up for success. Let's dive into the key steps to do just that.

FIRST, UNDERSTAND YOUR RETIREMENT CASH FLOW NEEDS AND TAX SITUATION

Before we get into picking assets and funds, we must first clarify your expected cash flow needs and tax situation in retirement.

Key factors to assess and quantify include:

  • All sources of expected retirement income, such as
    • Social Security benefits
    • Defined benefit pensions
    • Annuities
    • Rental income
    • Part-time or consulting work
  • Your estimated annual expenses in retirement, factoring in
    • Essential living costs like housing, food, healthcare, transportation, etc.
    • Discretionary lifestyle expenses like travel, hobbies, gifts, etc.
    • Potential large one-time expenses like home renovations or a new car
  • The gap between your annual income and expenses that will need to be bridged by portfolio withdrawals
  • Your federal and state tax bracket in retirement
  • How different types of investment income will be taxed based on account type (taxable, tax-deferred, or Roth)

Analyzing these cash flow and tax inputs lets you develop a realistic picture. You'll see how much you'll need to withdraw from your investments each year to fund your retirement vision. You'll also see how those withdrawals will impact your taxes. Equipped with this information, you can move on to the next planning step: determining your strategic asset allocation.

CREATING A TIME-SEGMENTED INCOME BUCKETS APPROACH

One retirement income strategy that has gained popularity in recent years is the time-segmented approach, also known as the "bucket" strategy. This approach involves dividing your retirement savings into separate pools or "buckets," each invested differently based on your short-term, medium-term, and long-term income needs.

The basic idea is to align your investment time horizon with your expected withdrawals, so you're taking an appropriate amount of risk with each portion of your portfolio. Here's how a time-segmented income buckets approach typically works:

Bucket 1 (Short-term needs): This bucket holds the cash and short-term fixed-income investments needed to cover your living expenses for the next 1-3 years. This money should be kept completely safe and liquid since you know you'll need to spend it soon. Examples include cash equivalents like money market funds, CDs, or short-term bond funds.

Bucket 2 (Medium-term needs): The second bucket is designed to replenish Bucket 1 over the next 3-10 years. It would be invested more conservatively than your long-term money, but can take on slightly more risk than Bucket 1 in pursuit of modest growth. This bucket is often held in bonds and other fixed-income investments.

Bucket 3 (Long-term needs): The third bucket is money you won't need until 10+ years in the future, if ever. This bucket is focused on growth to combat inflation and is invested more aggressively, primarily in equities. Over time, gains from Bucket 3 can replenish Buckets 1 and 2 as they are drawn down for income.

The exact time periods of each bucket and the investments used can be customized based on your personal risk tolerance, income needs, and retirement timeline. The key is segmenting your money by time horizon and investing each bucket appropriately. Then as you move through retirement, you can periodically "refill" the most conservative buckets with gains from buckets further out on the time horizon.

Benefits of the bucket approach include:

Peace of mind: Knowing your short-term expenses are covered regardless of market conditions can provide a huge psychological benefit. Even if your long-term investments hit a rough patch, your immediate income needs are protected.

Flexibility: The bucket system can be adapted to your unique lifestyle needs and risk profile. You can adjust the size of each bucket and the specific investments used based on your personal circumstances.

Clear investment framework: Bucketing offers a logical system for aligning your time horizon and asset allocation. It can help you stay disciplined and avoid the urge to sell risky assets at the worst possible time.

Implementing a bucket strategy does require ongoing portfolio maintenance. As you spend down your short-term bucket, you'll need to periodically sell investments from the other buckets to replenish it. You'll also need to consider sequence of returns risk - the possibility of experiencing poor investment returns early in retirement. Drawing too heavily from depressed portfolios can accelerate the depletion of your savings.

Despite these caveats, many retirees find the income buckets approach to be an intuitive and effective way to balance their need for stability with their need for long-term growth. If this concept appeals to you, consider working with a fiduciary financial advisor to customize a time segmentation plan for your retirement portfolio.

CRAFTING YOUR TARGET ASSET ALLOCATION


Your asset allocation - the percentage of your portfolio invested in stocks, bonds, and other assets like real estate or cash - is one of the most important drivers of your overall investment returns and risk exposure. Especially in retirement, it's critical to strike the right balance between growth and stability.

An overly aggressive portfolio has a lot of stocks. It might grow a lot in up markets, but could also have big losses in a crash. That volatility is tough for retirees to stomach, as they have less time to recover and may be forced to sell investments at depressed prices to fund income needs.

But, a too-conservative portfolio has too few growth assets. It could fail to keep pace with inflation in a long retirement. This means your purchasing power - the amount of goods and services your money can buy - would steadily decline, potentially leading to a reduced standard of living in your later years.

So how can you determine the optimal asset allocation for your unique situation? Consider these key factors:

  • Your risk tolerance and capacity: Risk tolerance refers to your emotional ability to handle investment volatility, while risk capacity relates to your financial ability to endure losses. Think about how much fluctuation in the value of your portfolio you could stomach without panic-selling. Also assess how a significant market decline could impact your retirement financial security and spending levels.
  • Your investment time horizon: Even in retirement, your investment time horizon may still span multiple decades. The longer your money needs to last, the more growth potential you'll need to build into your asset allocation to fund your later years. As you age, it often makes sense to gradually shift towards a more conservative posture to protect against sequence of returns risk.
  • Your spending flexibility: Do you have room to tighten your belt and reduce spending if needed during market downturns? Or are your expenses relatively fixed? The more flexible your spending needs, the more risk you can potentially afford to take with your asset mix.
  • Other Sources of Retirement Income: For some people, retirement expenses will be covered by reliable lifetime income streams, like Social Security and pensions. So, you may have more leeway to invest for growth with your remaining assets. Conversely, if you'll be relying heavily on your investment portfolio for income, a more conservative allocation is likely prudent.

Your ideal asset allocation will depend on careful analysis of the factors above in the context of your total financial picture.

It's also important to diversify within your overall stock/bond mix by spreading your money across different asset classes and geographies. Within equities, you might consider categories like:

  • U.S. large-cap stocks: Shares of large, established American companies
  • U.S. mid-cap stocks: Shares of medium-sized American companies
  • U.S. small-cap stocks: Shares of smaller American companies
  • International developed markets stocks: Shares of companies based in other developed countries like Japan, UK, Germany, etc.
  • Emerging markets stocks: Shares of companies based in developing economies like China, India, Brazil, etc.
  • Real estate investment trusts (REITs): Companies that own and operate income-producing real estate

On the fixed income side, potential asset classes include:

  • U.S. Treasury bonds: Debt issued by the federal government, considered very low risk
  • Investment-grade corporate bonds: Debt issued by high-quality U.S. companies
  • High-yield bonds: Higher-risk debt issued by lower-quality companies, offering more yield but also more potential for default
  • Municipal bonds: Debt issued by state and local governments, often tax-exempt at the federal level
  • International bonds: Debt issued by foreign governments and companies, diversifying outside the U.S.
  • Treasury Inflation-Protected Securities (TIPS): Special Treasury bonds that are indexed to inflation to preserve purchasing power

The key is to mix investments. They should work together to give the returns you need. These returns will fund your retirement and help you reach your other financial goals. By thoughtfully diversifying across asset classes that have different expected risk and return profiles, your portfolio won't be overly dependent on any one area of the market. You'll never shoot out the lights, but you should have a smoother ride towards your objectives.

IMPLEMENTING YOUR PORTFOLIO

With your target asset allocation as a blueprint, the next step is selecting specific investments to bring it to life. This is where you'll need to decide between two broad approaches: active vs. passive investing.

Active Investing

Active investing revolves around the idea that skilled portfolio managers can beat the market. They do this through tactics like studying company financials, making economic forecasts, and trying to time the market by jumping in and out of investments. The appeal of active management is the tantalizing potential to earn benchmark-beating returns. However, that potential comes with tradeoffs like higher fund expense ratios, elevated portfolio turnover (and resulting taxes), and manager risk. Active funds are run by professional managers who make all buy and sell decisions.

Research by Morningstar found that only 23% of all active funds topped the average of their passive counterparts over the 10-year period ending Dec. 2019. The active success rates were even lower over longer time horizons. This inconsistent track record (which is backed by many academic studies) is a key reason why passive investing has exploded in popularity in recent decades, now accounting for nearly 50% of all U.S. stock fund assets.

Passive Investing

Passive investing operates under the premise that instead of trying to outperform the market, investors are better off simply trying to match it as closely and cheaply as possible over time. Passive strategies aim to deliver the overall return of a market index (like the S&P 500) by owning all its underlying components in the same proportions. Since passive funds simply track an index with little trading activity, their costs are significantly lower. Over time, the majority of active funds underperform their benchmark index after accounting for fees.

Research by Morningstar found that only 23% of all active funds topped the average of their passive counterparts over the 10-year period ending Dec. 2019. The active success rates were even lower over longer time horizons. This inconsistent track record (which is backed by many academic studies) is a key reason why passive investing has exploded in popularity in recent decades, now accounting for nearly 50% of all U.S. stock fund assets.

For most retirement investors, the best way to get market returns and save on costs is likely building a diversified portfolio. They can do this using index mutual funds or exchange-traded funds (ETFs). These passively managed vehicles allow you to easily and cheaply gain exposure to a broad basket of securities representing different areas of the market.

When comparing index funds or ETFs, be sure to look closely at the following factors:

  • Expense ratios: This is the annual fee charged by a fund, expressed as a percentage of your investment. Even small cost differences can have a big impact on your ending wealth over time. For context, the asset-weighted average expense ratio was 0.06% for U.S. equity index ETFs and 0.12% for U.S. equity index mutual funds in 2019 according to the Investment Company Institute.
  • Tracking error: Measures how closely a fund's performance matches its underlying index. The lower the tracking error, the better the fund is delivering on its objective. Tracking differences can be caused by factors like fees, transaction costs, and portfolio sampling.
  • Bid-ask spreads: The difference between the highest price a buyer is willing to pay ("bid") and the lowest price a seller is willing to accept ("ask"). Bigger spreads mean more indirect costs for investors and less liquidity. Prefer ETFs with tight spreads.
  • Assets under management (AUM) and trading volume: Larger funds with higher trading volume are generally more liquid and have lower trading costs. Be wary of thinly-traded ETFs with low AUM.
  • Tax efficiency: Funds that frequently sell securities to raise cash for withdrawals or rebalance holdings can generate capital gains distributions that are taxable to investors in taxable accounts. All else equal, favor more tax-efficient funds

Carefully evaluating these characteristics allows you to be a discerning consumer in the ever-expanding universe of index products. By tilting towards the most low-cost, tax-efficient, well-constructed funds, you can further stack the deck in your favor as a long-term investor.

That said, you don't have to go it alone in the fund selection process. Consider consulting with a fiduciary financial advisor. They are fee-only and can provide objective guidance. They can also help you design a personalized portfolio aligned to your needs. A retirement specialist can also help with other important areas. These include creating a tax-wise withdrawal strategy, picking the best time to claim Social Security, and evaluating insurance options.

ONGOING PORTFOLIO OVERSIGHT

Effectively managing your portfolio doesn't stop after the initial setup. Your investments need regular care and maintenance over time, just like your physical health. Two techniques to keep your portfolio on track are rebalancing and tax-loss harvesting.

Rebalancing

Rebalancing is the process of periodically buying and selling assets within your portfolio to maintain your target long-term asset allocation. As markets move up and down, your portfolio's exposures to different asset classes can drift from their original targets.

For example, let's say your portfolio started with the following weights:

  • 50% U.S. stocks
  • 10% International stocks
  • 40% U.S. bonds

After a year when domestic stocks soared and bonds struggled, you might find that mix has shifted to:

  • 60% U.S. stocks
  • 12% International stocks
  • 28% U.S. bonds

To get back to your intended allocation, you'd need to sell some of your stock winners and repurchase lagging bonds to restore the balance. In this way, rebalancing forces you to follow the age-old advice to "buy low, sell high" and serves as an automatic contrarian investment approach.

How often you need to rebalance will depend on your personal risk tolerance, transaction costs, and tax situation. One approach is to set percentage bands around each asset class, such as +/- 5 or 10%, and rebalance when the allocation moves outside those limits. Another strategy is to rebalance on a set time schedule like quarterly or annually.

Tax-loss Harvesting


Tax-loss harvesting is another important tax management tool that involves selling investments trading at a loss to offset realized capital gains and/or ordinary income. The tax code allows you to deduct capital losses of up to $3,000 per year on your federal income tax return (or $1,500 if married filing separately).

If your losses exceed that cap, the excess can be carried forward to future years indefinitely. And even if you don't have capital gains to offset, losses can still be banked to shelter gains down the road. After harvesting a loss, proceeds are typically reinvested in a similar (but not "substantially identical") security to maintain your portfolio's asset allocation and expected risk/return profile.

This strategy is most valuable for investments in taxable brokerage accounts. It is less useful for retirement accounts like 401(k)s or IRAs. That is because investment gains in those accounts already grow tax-deferred. It's also important to be mindful of the "wash sale rule," which disallows a loss if you purchase the same or a "substantially identical" security within 30 days before or after a sale.

You might harvest losses every year, quarter, or when the market is volatile. The timing depends on your situation and market conditions. By proactively realizing losses when available, you can significantly reduce your tax bill and improve your portfolio's after-tax returns over time.

If manually rebalancing and harvesting losses regularly seems like a hassle, consider working with a financial advisor who offers these services. Or, use a robo-advisor that automates the process to your specifications.

PUTTING IT ALL TOGETHER WITH ASSET LOCATION

Thus far, we've covered how to build a well-diversified portfolio aligned to your risk tolerance and return objectives and manage that portfolio tax-efficiently over time. One final optimization technique to consider deploying in retirement is strategic asset location.

Asset location refers to the process of deliberately placing investments in the most tax-efficient account type based on their unique characteristics. The key is taking advantage of the different tax treatment of the three main account types:

  • Taxable brokerage accounts where investment gains are subject to applicable capital gains and dividend tax rates
  • Tax-deferred accounts like traditional IRAs and 401(k)s where contributions are made pre-tax, investment growth is tax-deferred, and withdrawals are taxed as ordinary income
  • Tax-free Roth accounts like Roth IRAs and Roth 401(k)s where contributions are made after-tax, investment growth is tax-free, and withdrawals are tax-free after age 59½ (if the account has been held for at least five years)

Each investment you own has its own tax characteristics. For example, stocks tend to be better for taxes than bonds. This is because stock returns come mainly from price growth, which isn't taxed until you sell. In contrast, bond returns come from interest payments, which are taxed as ordinary income.

In general, it's best to put tax-efficient assets, like stocks and stock funds, in taxable accounts. Put less tax-efficient assets, like bonds and REITs, in tax-deferred accounts. Put the highest-growth assets, like emerging markets stocks, in Roth accounts. By doing so across your entire portfolio, you can reduce drag from taxes and end up with more money to spend in retirement.

The best place for your assets depends on your account balances. It also depends on the returns of each asset class and your taxes. If your tax-deferred balances are large relative to your other accounts, for example, you may need to locate some tax-inefficient bonds in your taxable account to maintain your overall allocation. If you're in a high tax bracket, the benefits of keeping taxable bonds in your retirement accounts will be magnified.

Nonetheless, even a less-than-perfect asset location strategy is still worthwhile. A Vanguard study estimated that constructing a portfolio with asset location in mind can add up to 0.75% in additional after-tax returns per year compared to a tax-indifferent portfolio. Over a multi-decade retirement, that can translate into significantly more ending wealth.

CONCLUSION

Pulling together the many elements of a comprehensive retirement investment approach is no small task. But, if you take the time to understand key ideas like diversification, allocation, tax optimization, and disciplined management, you can make better choices with your savings.

To recap, here are the key steps we've covered to design your investment strategy for retirement success

  • Develop a realistic estimate of your annual retirement spending needs and expected income from all sources
  • Analyze your projected tax situation to understand how different types of investment income will be taxed
  • Set an appropriate strategic asset allocation based on your risk tolerance, time horizon, spending flexibility, and other unique factors
  • Diversify your portfolio across a range of equity and fixed-income asset classes and geographies
  • Implement your target asset allocation using low-cost, tax-efficient index mutual funds and/or ETFs
  • Rebalance your portfolio regularly to stay within your risk parameters and harvest losses to offset gains
  • Locate your assets optimally across taxable, tax-deferred, and tax-free accounts to further increase tax efficiency

While these fundamentals form a solid foundation, what ultimately matters most is having the discipline to stick to your well-designed plan over time and through varying market conditions. That's often easier said than done when scary headlines or euphoric market highs toy with your emotions.

But remember: Short-term market movements are impossible to predict consistently. The only reliable way to capture the market's long-term returns is to ride out the inevitable ups and downs and stay invested. Adopt a long-term view. Build your portfolio around your goals, not short-term performance. This approach will position you to enjoy a fulfilling retirement doing what you love.

Consider teaming up with a retirement specialist to create a personalized investment plan. Stay flexible as your needs change. Embarking on retirement investing may seem scary at first. But, know that you're taking meaningful steps to make the most of this exciting new life stage.

👉 If you would like to get a FREE retirement assessment, click the link to schedule your 20-minute call to start the retirement assessment process.

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