Asset Allocation for Early Retirees

How cats dream of retirement

“Diversification and globalization are the keys to the future.”
–Fujio Mitari

A recent article on Done By Forty (with a hat tip to Matt Becker at Mom and Dad Money for pointing him in my direction) lamented the lack of advice about asset allocation for early retirees. Though I’d argue with the premise of his site – his goal shouldn’t be retirement, per se (you can read that article to determine what I think the goal should be) – he brings up a good point.

The vast majority of the financial planning industry focuses on the traditional path to retirement: work until retirement age, retire, and hope you don’t run out of money before you die.

Well, what happens when you break away from that mold? Most of the financial press wants you to believe that the only other outcome is WORK LONGER. That’s not the reality. There are some of us out there who will hit the exit ramp long before we have a Social Security net.

While we’ve previously discussed strategies for bridging the gap between early retirement and the age when you can withdraw from retirement accounts without a penalty, we haven’t looked at how, if at all, your investments should change when you’re in early retirement compared to the usual path of working until Social Security kicks in.

Generally, investment advice says to keep 110 – your age in equities and the remainder in fixed income. The reason for that is that you want to allow your retirement savings to grow by investing in stocks but you want to reduce the ups and downs of your portfolio by investing in bonds. Invest too much in low yield bonds too early, like going all in on Treasuries, and inflation will eat up your portfolio, leaving you to dumpster dive in your elder years.

Let’s see what happens if you stick to this advice.

Imagine a 40 year old couple who is going to get $1,000 each in Social Security at age 67. They will spend $1,500 a month on housing and associated costs (utilities, maintenance, insurance, etc.). They’ll spend $500 a month on healthcare, and they’ll spend $3,000 on lifestyle (food, entertainment, travel, etc.), totaling $5,000 in today’s dollars. Given inflation, both of normal cost of living and of healthcare, to retire today, they need about $1.76 million in assets.

I created a market and inflation simulation to see if this couple could make it to age 95 without running out of money. I used historical market returns for stocks, ranging from an annual loss of 44.2% to an annual gain of 56.8% and a median return of 10.5%, and for corporate bonds, ranging from a minimum annual gain of 2.5% to a maximum annual gain of 15.2% with a median gain of 5.2%, to determine this couple’s returns over time. Each year, the simulation picked a random return for stocks and bonds as well as choosing a random amount inflation, ranging from 10.5% deflation to 18% inflation with a median inflation of 2.8%.

I ran the simulation 10,000 times to see how often our couple had money at age 95.

They had a positive net worth at age 95 89.4% of the time. 50% of the time, they had more than $32.5 million, and 50% of the time, they had less than that amount.

When I construct model scenarios, I usually like to aim for a 90% or higher success rate. This is right on the borderline, but if this couple was a client of mine, I’d give them the go-ahead with a few warning signs to look out for.

However, recent research by Dr. Wade Pfau, CFA shows that you’re most vulnerable to poor market performance in the first few years of retirement. His research was limited to 30 years of earning income and 30 years of retirement, but in that research, he showed that returns in the first year of retirement explained more than 14% of the final outcome for those retirees. Since the risk is mainly poor market performance in those first few years of retirement – bad years compounded with withdrawals when the total amount of money that the retirees have is expected to be at its lowest – I decided to tweak the strategy to determine if I could improve on this couple’s outcome.

Instead of using the 110 – age asset allocation strategy that would lead to the couple being invested 70% in stocks the first year of retirement, I had them only 20% invested in stocks and 80% invested in corporate bonds for the first five years of their retirement. The results?

This time, they had money left over 93.4% of the time, and their median net worth was $30.6 million. A shift lower by about $2 million to get well into the safety zone is a tradeoff that I’d be willing to make.

If 5 years is good, then 10 years should be better, right?

Yes and no.

The couple had money left over 94.6% of the time – a much smaller increase in safety. They also had a median net worth of $28.4 million. They paid more for a smaller increase in the cushion.

This makes sense intuitively, as, aside from investing completely in annuities, it’s nearly impossible to gain complete safety when investing in the market. Additionally, the longer that the couple is so heavily invested in bonds, the more likely it is that inflation could catch them.

The counterintuitive approach that Dr. Pfau advocates for the first few years of retirement for people in their sixties seems to hold true for early retirees as well: shift into more conservative investments for a few years and then shift back into more aggressive investing. There’s a balance in asset allocation in retirement between being too conservative and having your portfolio decimated by inflation and being too aggressive and having unfortunate downturns in the market just as you retire destroy the value of your portfolio. Based on my analysis, portfolio protection in the first few years of early retirement seems to be a prudent approach in improving the chances of having your money outlast you.

Is this surprising information? What do you think? If you go conservative early in retirement, will you have the fortitude to dial the risk back up in a few years? Let’s talk about it in the comments below!

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Jason Hull was the co-founder of Broadtree Partners, a firm that acquires $1-5MM EBITDA companies. He also was the co-founder of open source search consultancy OpenSource Connections, a premier Solr and ElasticSearch firm. He and his wife FIREd (financial independence retire early) at 46 and 45, respectively. He has a BS from the United States Military Academy at West Point and a MBA from the University of Virginia Darden Graduate School of Business. He held a CFP certification from 2015 - 2021. You can read more about him in the About Page. If you live in Johnson County, Texas or the surrounding areas, he and his wife are cash buyers of Johnson County, Texas houses.

13 thoughts on “Asset Allocation for Early Retirees

  1. Very interesting. So in your second scenario, after 5 years is the porfolio immediately shifted back to 110-age in bonds or is the shift more gradual? I also wonder if the longer timeline allows you to be a little more aggressive in the early years, as you would have more time to make adjustments in your spending along the way. But in general I like the principle of paying a little bit in the form of end net worth for extra security in terms of not running out of money.

    1. Hey Matt – Thanks again for making the connection for me. In both “dial down” scenarios, there’s no gradual shift back. Given the relative sacrifice between the 5 year and the 10 year scenario, I inferred that gradually scaling probably wouldn’t drastically reduce risk, though I didn’t actually run that scenario.

      I don’t think that increasing the aggressiveness early on makes things better for the reasons Wade cites in his research. The biggest risk for retirees, be it at 65 or at 40, is a negative shock in the first few years of retirement. Being more aggressive in investing just increases the risk of that shock. The upside is higher, but the downside means going back to work. The target number has some ability to survive a downturn in the market, but not an infinite capacity to do so.

      There are other strategies that someone could pursue to improve the chances of not running out of money, but they’re beyond the scope of this article and really are something that a person would want to have a detailed consultation with a planner to discuss. If someone is contemplating early retirement and isn’t well above a target number in assets for an extremely secure retirement, then spending $1-2k on a planner for a detailed consultation would be a wise investment. I wouldn’t try to reconstruct my own knee using YouTube and a bunch of forum posts; the analogy holds true here as well.

  2. So I think I wasn’t clear in my first question. In your second scenario, you write that “I had them only 20% invested in stocks and 80% invested in corporate bonds for the first five years of their retirement.” I’m curious what the allocation looks like in that 6th year and beyond.

    Thanks again for the explanation. I completely agree with you about the value of working with a planner. If nothing else, it can at least make you feel like you’re plan is custom-tailored exactly to your situation, which behaviorally can be a great benefit. And in many cases there are specific circumstances and goals that cannot be accounted for in a generic post. But this information is a great starting point.

      1. Cool. And just to be clear, in my original question about possibly being more aggressive, my line of thinking is that you have more time to adjust spending, not more time for the market to recover. It would really depend on the individual’s specific situation, but if your withdrawal rate includes a decent amount of fluff then you could potentially make the choice to pursue a more aggressive strategy, knowing you could cut some of that fluff out if you had to. Certainly not the go-to choice for everyone, and I’m still not sure if it makes mathematical sense, but that’s where I was going with it.

        1. Absolutely. No withdrawal rate should be totally static. If a family’s assets drop below a certain point, then they’ll need to dial back on spending. I’d rather them go that way, as you allude to, than to dial up the aggressiveness in investing to try to make up for it. All that does is start the process of making increasingly risky bets trying to get back where they were.

          Furthermore, if you’re so tight on the budget that you cannot withstand a dip in the market, you’re not ready to retire in the first place.

      2. One more thought. It’s pretty interesting that Pfau’s research looks at a 30-year retirement and deems the first few years to be most vulnerable. Here, when looking at a 55-year retirement, it’s still those first few years even though after that point you’re still looking at 20 years BEFORE you get to the 30-year mark. Wouldn’t logic say that once those next 20 years have passed you’re now looking at a 30-year retirement, and therefore those next few years need to be invested conservatively (based on Pfau’s research)? I guess I’m a little confused as to why it’s just the first few years of whatever period that matters, and not something like “for the last 25 years of retirement you can start getting more aggressive, but before that you need to be more conservative”.

        1. Success at any retirement period depends on the ability of your assets to at least grow to match inflation. The initial period of portfolio risk is due to that fact that you’re no longer contributing to it while withdrawing from it. There’s a tipping point in each retirement scenario where, if you drop below a certain amount of assets, you simply cannot recover – not because you continue to withdraw at a safe withdrawal rate, but because you’re withdrawing at an inflation-adjusted constant spending rate. Yes, the correct answer in that situation is to adjust your spending, and not your investments, but people tend to be on the hedonic treadmill and find it difficult to make those spending adjustments.

          The goal in calculating a retirement number in the first place is to allow someone to retire at the standard of living that they desire without having to make adjustments, except for the natural spending declines which occur later in life.

          Therefore, the time period doesn’t necessarily matter because you’ve adjusted the target number to account for the number of years in retirement. The target number takes into account the fact that you’re no longer contributing to your retirement savings and the only growth from retirement through passing will be from capital gains, dividends, and interest.

          Regardless of the amount of time you’re retired, you don’t want your portfolio to approach that tipping point where, if you maintain your spending, the portfolio can never recover. Keeping a conservative portfolio for the first five years means that you maintain, roughly, the same level of assets, but, since you’ve bought five years, you’ve lowered the tipping point. However, staying too conservative too long means that inflation will drag the tipping point back up, over time, and if your portfolio isn’t growing appropriately, inflation will catch you.

          Retiree investments have to maintain a balance between letting inflation catch them on one end – in being too conservative – and letting downturns in the market catch them on the other end – in being too aggressive.

  3. Jason,

    Thanks so much for this post (and the mention!). The data is fantastic to see in those charts, too. I would never have thought to go so heavy into fixed income but, understanding that the first few years of early retirement are the lynchpin, it makes sense. Playing defense for the first five years really decreases the likelihood of running out of money.

    I had a follow up question. If you had a client who was planning an early retirement this year, with bonds being potentially subject to some serious interest rate risk, might simply holding some of those bond funds (or most of them) in cash be a decent idea?

    1. Hey, DBF – thanks for the kind words and for asking the thought-provoking questions. To answer your other question, I’ll pose a question back to you: how good are you at timing the market?

      I have a forthcoming article about another financial advisor who tried to convince me that the right thing to do was suggest that all of my older clients get out of bonds because quantitative easing was ending. I have a couple of charts that show just how good that person’s market timing was.

      In all seriousness, I would have expected to see inflation by now given how much money is supposedly flooding the market; however, there’s an excellent analysis over at Don’t Quit Your Day Job about why we haven’t seen inflation.

      If I reacted to every time someone passed gas in the market, my neck would be sore from the bullwhip effect. I think that I, and retirees, have more important things to do with our time than to try to watch the markets every day. Once you start trying to watch the markets, you see patterns in numbers that aren’t there, and you subject your investing to the whims of Monkey Brain.

      Retirees, whether they’re retiring in their 60s or their 30s, have a long time horizon. Focusing on daily minutiae or even media gyrations will only cause us to veer from our plan.

      If you’re so close to the edge that you don’t feel comfortable in your plan if the market burps, you aren’t ready to retire yet.

  4. Hmm.

    Interesting data, but what if you’re not interested in investing in the financial markets? My goal is to retire early(ish, at this point) by having my cash flow via rental real estate, business investments, etc. exceed my expenses. I will certainly have some investment in the stock and bond markets, but hopefully significantly less than half.

    Much harder to predict without the historical data available for the equities markets. Any thoughts on asset allocation for non-traditional retirement plans?

    1. Here’s an article about managing early retirement needs using rental properties.

      I’m a big fan of real estate and small business if you know what you’re doing.

      How to allocate among them? Impossible to say in one broad sweeping generalization. What is the EBITDA multiple of the business investment? How liquid is that market? Growth projections? Should I use DCF instead? What’s the weighted cap rate of your rental properties? Etc.

      For people who want that level of detailed analysis of their retirement plans, they need to contact me to discuss setting up an engagement to perform a more detailed analysis of where they’re going.

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