By Dr. Jim Dahle, WCI FounderTraditionally, the intelligent way to manage a portfolio is to use a fixed asset allocation, such as our asset allocation:
- 40%: US stocks
- 20%: International stocks
- 20%: Real estate
- 10%: Nominal bonds
- 10%: Inflation-indexed bonds
You rebalance once a year or so (or as you go along with new contributions) back to those percentages, which constantly forces you to buy low and occasionally sell high if needed. It's a very simple system and relatively easy to teach and to do, so long as you possess some basic spreadsheet, login, and order entry skills. But it is not the only way to manage a portfolio, particularly when it comes to the bond portion. Some people actually put a fixed amount of dollars into bonds, rather than a fixed percentage.
Emergency Fund Style
One way to determine the amount to leave in bonds is the method many people use for their emergency fund. They set up an emergency fund with 3-6 months worth of expenses in cash. Those who use this method with their bonds put enough money in bonds to cover something like three years worth of expenses. Everything else in the portfolio goes into stocks (or real estate or whatever). So, if you plan to spend $100,000 a year, you have $300,000 in bonds and the rest in stocks, whether the rest is $100,000 or $10 million.
Maybe the idea is that if the stock market tanks and you decide to retire at the same time (or you're already retired), you can then spend from your bonds for up to three years, and hopefully by then, your stocks will have recovered and you can presumably replenish the bond portion of the portfolio. Meanwhile (during both accumulation and decumulation), you can get the higher growth you expect out of having more money in stocks.
There are some issues with this method. In a classic retiree portfolio where you're spending 4% a year, that would suggest an asset allocation of 88/12, which seems pretty aggressive to me for a retiree. Plus, when are you supposed to start this? Are you really going to put the first $300,000 you save for retirement in your 20s or 30s all into bonds? That seems pretty odd. Presumably, you'd have to decide to adopt this method at some point as you approach retirement, but getting the timing right seems challenging.
I think some people considering this are just chasing performance. They look at the last 5-10 years of US stock returns and then they look at bond returns over that time period (or maybe just 2022) and decide they're missing out by not owning more stocks. They determine that they can justify a more aggressive asset allocation with a fixed dollar amount of bonds than a fixed percentage of bonds, so they make the change.
More information here:
How to Build an Investment Portfolio for Long-Term Success
The 15 Questions You Need to Answer to Build Your Investment Portfolio
Liability Matching Portfolio
The other folks I see doing a fixed amount of dollars as their bond allocation subscribe to the Liability Matching Portfolio (LMP) school of thought. Bill Bernstein is a big fan of this idea, which he summarizes as, “When you realize you've won the game, stop playing.” The idea is that you're matching future asset sales and income streams against the timing of expected future spending. Classically, this is done by annuitizing part of the portfolio (especially back when inflation-indexed Single Premium Immediate Annuities [SPIAs] could be purchased), but nowadays, it seems more common to use a 10- or even 30-year ladder of Treasury Inflation Protected Securities (TIPS). You basically buy a TIPS equal to your annual spending (or at least your required spending) for each year of your retirement. Then, when the TIPS matures, you spend it. If you have any money left over after building this ladder, you invest that aggressively for one of five purposes:
- In case you live longer than 30 years.
- In case you want to spend more than the TIPS will provide.
- In case your personal inflation rate is much higher than the CPI rate that TIPS uses.
- To provide an inheritance to your heirs.
- To leave money to charity at your death.
As you approach retirement, this method makes a lot of sense. Depending on your wealth and spending, you might end up with a 20/80 portfolio or an 80/20 portfolio. However, earlier in the accumulation phase, you can see some real problems. Imagine you need to accumulate $3 million-$4 million. Are you really going to invest the first $3 million all into TIPS? Seems a bit conservative for a 30-year-old, no? Maybe you never get to $3 million in TIPS and die at 76 before you have enough to retire using this method.
More information here:
How to Determine Your Ratio of Stocks to Bonds
Retirement Income Strategies — And Here’s Our Plan for When We FIRE
What Should You Do?
I still think the fixed percentage method is just fine, especially for accumulators. The LMP system is theoretically quite robust for retirees, but I wouldn't adopt it until I was at least within five years or so of retiring. Where a traditionalist might start dialing down the asset allocation (or forming a bond tent for those Sequence of Returns Risk years), the LMPist builds out a TIPS ladder plus/minus a nominal SPIA or two.
The emergency fund method is fine, but I wouldn't feel secure with just three years worth of spending in bonds as a retiree. I think I'd want more like 10, which gets most people spending 4% at least down to a 60/40 portfolio or so.
Your stock-to-bond split is the most important aspect of your asset allocation, so choose it carefully. It's probably most important not to be more aggressive than you can emotionally handle without panic-selling in a nasty bear market, but it's a constant exercise of balancing your Fear of Loss with your Fear of Missing Out (FOMO). The problem is that these fears are not necessarily constant. The former tends to get larger in a bear market, and the latter gets larger in a bull market.
But do the best you can at setting your asset allocation at what you can handle in a bear and then not letting your FOMO make you too aggressive later.
What do you think? How did you set your bond allocation? Did that change over time? Why or why not?
We’re using 86/4/10 because I ‘ve earned ~$150K in pensions (military, civil service, and eventually SS). The 4% is for four years of SORR mitigation though I don’t credibly expect to need it with $5M in portfolio.
Thanks for all that you do!
If 4% of bonds represents 4 years of spending, I’d be curious of your annual burn rate! Fellow military retiree here, and even with a pension, I’ll still keep an 80/20 allocation after retirement to weather up to a 5-year downturn. Is that last 10% allocation real estate or cash?
Congrats on earning your retirement!
10% is in REITs. 25-33% of each broad allocation is international. I also tilt to small value and emerging markets.
I’m still working so not sure of a retired-retired burn rate, currently consuming $120K, 100K to investments, the rest goes to taxes. Am astonished to pay more to the various tax men than I earn in mil retirement. First world problem, I know.
I expect to start converting conventional TSP to Roth IRA next year when available. Plan to stay under the next higher IRMAA and tax rate line though.
For younger physicians with a stable income and a 30-year accumulation horizon, human capital is a perfect equivalent of bonds. I believe that for that cohort, the only reason to keep bonds in the portfolio is to prevent volatility for better sleep. With good risk tolerance, even 10% may be excessive.
With human capital waning with the years, bond funds serve as a ballast for the portfolio, providing some cushion during an unavoidable market crash. But I don’t think we can use bond funds as emergency liquidity. That role should belong to liquid assets such as cash, T-bills, MYGAs, and CDs. Five years of spending in liquid assets can significantly decrease the need for bond funds in a portfolio.
During retirement, the size of the bond cushion will further depend on the amount of guaranteed income from a pension or annuities. The closer the amount of guaranteed income – TIPs or nominal bonds ladder, annuity payments, Social Security benefits – matches the liability of mandatory expenses, the less cushion we will need. TIPs would be the best tool for inflation-adjusted income, but to build a ladder for 30 years with $100,000 annual income will require, based on my Excel calculation, from $1.8 to $2,6M in present value investment. Plus, to build such a ladder in a taxable account, using TreasuryDirect, will be very tax-painful. To do that in an IRA, buying individual TIPS on the secondary market, would be technically challenging, and the cost of transactions may add up very rapidly. And what if you live longer than 30 years? A DIA/QLAC combination can provide similar, but lifelong income for about $1.2M.
Right now, pretty close to retirement, I have a 10/25/65 combination of cash/bond funds and ladder/equities.