Those who are nearing retirement and those who have recently retired represent the majority of my financial planning and investment advisory client base. One of the most common mistakes I hear from these types of individuals is something similar to “I no longer have enough time for the market to come back.”
Is this really true? A 65-year-old couple has about a 50% chance of one of them living until age 90, and about a 1 in 5 chance of one of them living until 95. For planning purposes, this means that in most situations it’s not unreasonable to stress test a retirement financial plan until age 95 or even 100. This is 30+ years. When it comes to asset allocation (your portfolio mix of stock funds, bond funds, and cash), two questions should be answered:
- How many years until I expect to begin withdrawing money from my investments?
- Once I begin withdrawing money from my investments, how many years do I expect that to last?
From my experience, the average investor only thinks in terms of question #1 when thinking about how their portfolio should be allocated, yet question #2 is equally as important.In general, the asset allocation for an 18 year old’s 529 account should have a significantly lower allocation to stock funds than a 65 year old’s IRA.
Once someone begins taking withdrawals to pay higher education expenses, the entire account would typically be expected to be depleted within 4-5 years. This means that the allocation to stocks should be very low at this point because market volatility is the most significant risk.
Once someone begins taking withdrawals for retirement, the planning process would require there to be a sufficient probability the account(s) might last at least 30 years, as described earlier. Risk at this time horizon begins to transform from being primarily about short term market volatility into inadequate rate of return to keep pace with inflation adjusted living withdrawals.
For example, in recent history the worst time to begin taking withdrawals from an investment account would likely have been at the end of 2008, which is when the Global Financial Crisis was near its peak uncertainty and stock declines were substantial for the calendar year. For example, the US equity market lost 37% and Foreign equities lost 44%.
College Funding Example: $100,000 account, withdrawing $25,000 per year at the end of each year starting in 2008:
Portfolio 1: A 100% Global Equity Fund was only able to withdraw a total of $76,269 due to the losses experienced in 2008. A permanent loss of $23,731 occurred due to the requirement to take large withdrawals to cover expenses.
Portfolio 2: A 10% Global Equity, 40% Intermediate Term Bond, 50% Money Market Fund portfolio had a $5,348 balance after 4 the year perioddue to investment earnings.
The difference in this example is stark. In the first example, there are insufficient funds left to pay for the vast majority of the final year’s expenses. In the second example, funds are left over that could be used for a variety of purposes such as a graduation gift or applied to the next child in the household. Now, let’s take the same portfolios, but shift the withdrawal example to a hypothetical retirement scenario where we withdraw $40,000 at the end of each year from a $1,000,000 account instead of $25,000 per year from a $100,000 account.
Portfolio 1 on January 31, 2020: $1,784,353
Portfolio 2 on January 31, 2020: $819,899
Once again, the difference is stark, but in the complete opposite way from the first example. This time, where the withdrawal amount is much lower to account for the difference in time horizon, portfolio 1 has dramatically increased in value while portfolio 2 is slowly disappearing, like a melting ice cube. This is due to the insufficient rate of return of cash and bonds to keep up with the amount withdrawn and would make it apparent to any retiree that tough decisions may need to be made in the near future. Portfolio 1 experienced a significant initial decline, but since only a small amount of the portfolio needed to be sold and withdrawn to meet living expenses the vast majority of the account was left intact to be able to participate in the market recovery that has followed.
Conclusion
Time horizon is a critically important component to asset allocation decisions for an investment portfolio and has a significant influence on the primary risks involved. All too frequently, investors only consider their time until they begin withdrawing money from their accounts as their time horizon, while the total number of years the account may be utilized is more appropriate. This article highlights how parents paying for a child’s college education starting within the next year have a different time horizon than those same parent’s taking withdrawals for their own retirement within the next year. It may be appropriate for one account being used for education funding to have very little in equity funds while the other account might be almost entirely in equity funds and other equity like strategies since the money may need to last for 30 years or more.
Jesse Blom is a licensed investment advisor and Vice President ofLorintine Capital, LP. He provides investment advice to clients all over the United States and around the world. Jesse has been in financial services since 2008 and is aCERTIFIED FINANCIAL PLANNER™professional. Working with a CFP® professional represents the highest standard of financial planning advice. Jesse has a Bachelor of Science in Finance from Oral Roberts University. Jesse manages theSteady Momentumservice, and regularly incorporates options into client portfolios.
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