Basic stuff for some of us; gibberish for others. So if you have difficulty with this, ask your financial advisor for help.
Dana Anspach on April 6, 2017
Smart investors follow an asset allocation plan.
An asset allocation plan tells you how much of your total investments should be in stocks versus bonds and then gets into additional detail, such as how much should be in large company U.S. stocks (or index funds) vs. international vs. small cap.
You maintain investment ratios by rebalancing on a predetermined basis, such as once a year. In a 401(k) plan, rebalancing is often accomplished automatically by checking a box that says something like “rebalance every x months to this allocation.”
In general, while you are saving, rebalancing can be easy. If you should have 10% of your investments in small cap, and you only have 5%, when you fund your IRA, you put it in a small cap fund.
This process gets more complex as you accumulate different types of accounts. You may have a 401(k), an IRA, a Roth IRA, or a 403(b). If a married, your spouse may also have multiple types of accounts. Maybe you also have a deferred comp plan or stock options. Now rebalancing must encompass which types of investments should be in which accounts. While working, as you add money to accounts you can make progress on maintaining the right balance by putting new deposits into the investment type that is most needed.
When you retire, if you have multiple types of accounts, it gets more complex. Should you withdraw from the S&P 500 Index SPX, +0.11% fund in your brokerage account first, or sell a portion of the stable value fund in the 401(k)? Some 401(k) funds won’t allow you to choose which fund to sell. You may have to take withdrawals proportionately from each investment type, which isn’t necessarily a bad thing, but it limits flexibility in how you manage your investments.
If you have enough wealth, rebalancing won’t matter. I have one client who has about $2 million with my firm and manages the bulk of his investments, another $6 million, at Vanguard. I recently asked him how he manages cash flow in retirement. He said when his checking account gets too low he sells something at Vanguard. Pretty easy for him. The amount he is selling is small compared with his portfolio size, so his decision will have an insignificant impact on his portfolio allocation.
Most retirees don’t have $8 million in financial assets. If you are a consistent saver, you may have $500,000 to $1.5 million; if you have a great job or inherited wealth, perhaps a bit more. You have enough to be comfortable, but the decisions on how you withdraw it will have a significant impact on your total wealth and available cash flow in retirement.
There are two primary approaches to rebalancing in the withdrawal phase: systematic withdrawals and time segmentation.
With systematic withdrawals, you withdraw proportionately from each investment type. For example, if you were withdrawing $30,000 from a $500,000 account which was allocated 60% to stocks and 40% to bonds, you would sell $18,000 of your stock holdings and $12,000 of your bond holdings, thus maintaining your 60/40 allocation. Systematic withdrawals are easy to manage if the bulk of your investments are in one account.
If you have multiple account types, systematic withdrawals are more difficult. For tax reasons, it often makes sense to withdraw from one type of account first, and that account may be allocated differently than other accounts. And, if you’re married, your spouse may invest conservatively, while you invest more aggressively, or vice versa. Investing this way may not be optimal, but if you haven’t coordinated your plan as a household, this is often the reality. Multiple accounts with varying tax consequences and an uncoordinated allocation make maintaining an appropriately balanced portfolio while withdrawing more challenging.
With time segmentation, first, you develop a plan that tells you which accounts to withdraw from in which years. Next, you match up the investments in those accounts with the point in time where you plan to take the withdrawals. If you know you are going to withdraw $30,000 a year for the first five years from the IRA, you will have $150,000 of the IRA in safe, stable investments, like CDs or bonds with maturities matched to the year of the withdrawal, or low duration bond funds.
As with all investment strategies, there are pros and cons to any approach. The biggest problem is many people don’t have a plan at all. Having a well-tested retirement income plan brings peace of mind. A plan allows you to relax and enjoy your retirement years. If you are nearing retirement age and don’t have a defined rebalancing strategy in place that shows you when and how you will take money out, it’s time to get one.