The final years leading up to your retirement are critical from a financial planning perspective. During the last five to seven years of pre-retirement and the first few years of retirement itself, you will likely need to make subtle shifts in your retirement plan’s asset allocation to position yourself financially for a long and successful retirement.
Three Phases of Retirement Planning
For most people, planning financially for retirement is a long-term process that will likely take 40 years or longer. However, this time frame actually consists of three main phases:
- Accumulation — You’ll probably spend most of your life in this phase as you strive to save and accumulate as much money as possible in your retirement account.
- Consolidation — This is the final five to seven years before your planned retirement when you want to begin consolidating the assets you’ve worked a lifetime to accumulate.
- Distribution — This phase occurs after you enter retirement and you begin making withdrawals from your retirement account to support yourself and your spouse financially.
The accumulation phase of retirement gets a lot of attention, and rightfully so. However, if you fail to plan for consolidation and distribution of your retirement assets, you could jeopardize all the hard work you’ve put into accumulating these assets over your lifetime.
The Importance of Shifting Your Asset Allocation During the Consolidation Phase
During the accumulation phase, most people feel comfortable assuming more risk with their retirement investments. This is because you have a long-term time horizon for these assets, which gives you more time to make up short-term losses you may incur due to market volatility.
But when you reach the consolidation phase, it probably makes sense to shift your asset allocation to a more conservative mix of stocks, bonds, and cash equivalents. This is because you now have a shorter time horizon than when you were younger and less time to make up short-term losses before you reach the distribution phase.
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During the consolidation phase, it usually makes sense to shift your asset allocation mix so there’s less exposure to investments that may be more volatile in the short term (like stocks) and more exposure to those that generally have less volatility, such as fixed-income investments (like bonds) and cash equivalents.
The financial crisis of 2008-2009 is a good example of how making the wrong changes to asset allocation during the consolidation phase can have dangerous long-term outcomes. During this time, the financial markets suffered a steep selloff from which it took years to recover. In fact, it took five and one-half years for the Dow Jones Industrial Average to reach its pre-crisis level of 14,093 in October of 2007 again, which it finally did in March of 2013.
For individuals with a long-term time horizon, this five-year market drought was a blip on the radar, as the Dow is now closing in on 20,000. But for those who had planned to retire in 2008 or 2009, the market selloff would have caused a serious problem if they didn’t shift their asset allocation to a more conservative mix.
How to Generate Income During the Distribution Phase
Once you enter the distribution phase, you should probably adjust your asset allocation again. Traditionally, many retirees have shifted the bulk of their retirement portfolios to investments that generate current income they can tap to support their retirement lifestyle while preserving their principal. However, the current low-interest-rate environment has made this strategy more challenging than ever.
Generating income to pay living expenses in retirement today requires some creativity and out-of-the-box thinking. A few tools to consider that could help you meet the retirement income challenge are convertible and preferred securities, dividend-paying stocks and a diversified bucket of fixed income investments.
Given the low interest rate environment, investors need to be careful not to be overexposed to interest rate sensitive investments, like utility stocks and long-term bonds just to name a few, that could lead to investment losses when interest rates rise. Investors can potentially reduce interest rate sensitivity by shortening duration, buying lower quality issuers or going outside the U.S. for fixed income exposure. This should not be done blindly because you must continue to manage risk, fixed income diversification is good but you do not want to own too many investments with a high correlation to equities.
While preserving principle is usually of primary importance during the distribution phase, it could be wise to maintain some percentage of riskier stocks in your portfolio as well. With the average life expectancy on the rise, your retirement assets might have to last you for 20 to 30 years or longer — so you’ll likely need the long-term growth potential that stocks can provide.
How ACG Can Help
At ACG, we have experience in helping investors plan how to shift their asset allocation during the consolidation and distribution phases of retirement. Please contact us to learn more about how we can help you plan your asset allocation strategies.