Retirement Planning

While several factors need to be considered for asset allocation, including risk tolerance, the investment horizon is a key factor. This is because of the law of large numbers. As it relates to investing, the law of large numbers states that the longer an asset is held, the more the average annualized return can be expected to behave like the historical average for that asset type. This means that, while in any given year the return may be positive or negative, on average it should earn a return close to the historical average. This is important since, in the long run, stocks outperform all other asset types and small stocks tend to have the highest average return. One caveat is that this concept assumes that one holds a portfolio that is representative of the data. That is to say that owning one stock is not necessarily sufficient to assume that it should perform the same as the overall market. The idea is that one has a well-diversified portfolio that mitigates or eliminates any company-specific risks. This can be easily accomplished through the use of mutual funds, especially funds that are broadly based. One example of such a portfolio might be an index mutual fund that is based on the Standard and Poor 500.

The risk tolerance of an individual is the amount of risk that one is willing to assume in investment choices. This may be thought of as being related to the proportion of wealth that one would be willing to place in riskier assets such as stocks. Many financial planners will use some subjective measure of risk tolerance based on hypothetical scenarios. Using results from these measures, the planner formulates investment recommendations. However, a good planner will not only consider the client’s risk tolerance, but also more objective measures such as investment horizon (time until retirement).

A person’s asset allocation choice will determine the composition of the investment portfolio, that is the allocation of portfolio shares to stocks, corporate and government bonds, and money market instruments. Since stocks outperform all other investments in the long run, younger investors saving for retirement can take advantage of the time that they have before retirement and invest more aggressively. Some would say that individuals with at least twelve years or more to retirement should consider a portfolio heavily weighted with equities. However, as retirement looms closer and the horizon grows shorter, an all-stock portfolio is no longer an optimal choice because the confidence that stocks will have a higher return in the shorter-term decreases. At that time, it becomes prudent to shift some of the equity to fixed-income securities such as bonds or bond mutual funds. This uses the fixed return on the bonds to offset the increased volatility of the equity holdings. Therefore, in early working years, investors should be more aggressive when saving for retirement, and as investors approach retirement (within ten years or so) they should become more conservative.

At retirement, investors can spend accumulated asset to purchase a life annuity. This insurance contract promises an annual or monthly payment for the rest of one’s life in exchange for a lump sum payment. This eliminates the risk of outliving one’s assets, since the payments would be assured for one’s remaining life expectancy. There may be survivorship provisions as well in these contracts that provide income for surviving spouses or others. However, there is minimal control over the investment management of the annuity. Another potential disadvantage is that the annuity would not allow for advance payments which might be needed should any large one-time costs arise.

Other methods provide more control over assets. An alternative, the perpetuity approach, involves holding accumulated investments and using their proceeds for spending purposes. This gives the individual more control over distributions and investment management. However, without proper guidance, this approach increases the risk of outliving one’s assets. Some combination of both approaches may be more ideal, but is not necessarily feasible for households without significant wealth. A choice between the two approaches must therefore often be made. This choice can be made by comparing the perceived risk of asset shortfalls with the perceived risk of having any need for large distributions. One other consideration is the perceived opportunity cost of reduced management control. While annuities greatly reduce the shortfall risk, and the perpetuity approach allows the distribution amount to be determined by the investor. Another factor influencing this choice may be the desire to leave a bequest to heirs. While annuities may provide for survivorship, the ability to leave assets to heirs is much simpler when assets remain in the estate.

During retirement, assuming one does not annuitize all wealth, asset allocation becomes essential. Assets must maintain a level of return that will be sufficient to avoid shortfall and, potentially, provide for a desired bequest. The retirement asset allocation needs to include some highly liquid investments, as well as ones that will provide a reasonable rate of return. The use of money market transaction accounts might be advantageous, rather than a checking account, since money market accounts usually provide a real rate of return slightly higher than a regular savings account. Use of laddered Certificates of Deposit (CDs) can be useful as well. The laddered approach is to purchase CDs of varying maturities so that they mature as they are needed. Since there are other assets available in an emergency, these CDs should typically be able to be held until maturity. The remaining portfolio should be well diversified to minimize risk. Again, mutual funds may be ideal for this situation, as they bring inherent diversification.