Balance is key in life, and when it comes to financing your second act, rebalancing is just as critical.
There’s no shortage of reasons why investors rebalance their portfolios. Age, preservation of wealth and mitigating risk exposure during market volatility are all common motivators for rebalancing.
For those nearing retirement or who have recently retired, all three of those factors come into play. Rebalancing helps get your asset allocation — or the mix of stocks, bonds and other investments in your portfolio — back in line with your long-term goals. The purpose is not to maximize gains but rather to manage risk and ensure financial well-being throughout your post-work years.
Here’s what you need to know about when to rebalance and how to do it intelligently.
Rebalancing your portfolio as you approach retirement
Rebalancing is something you should do periodically throughout your investing timeline, but you typically don’t want to rebalance based on market conditions, says Kelly Regan, vice president and financial planner at Girard, a Univest Wealth Division. Instead, rebalancing should be dictated by life stages, and retirement obviously qualifies as a big one.
“Typically, a year out from retirement we start to get a little more conservative,” Regan says.
Here’s an example from history that shows why that’s so critical: In 2007, roughly 25% of 401(k) investors between the ages of 56 and 65 had more than 90% of their portfolios allocated to stocks, according to the Employee Benefit Research Institute.
When the Great Recession arrived that December, the S&P 500 went on to lose over 51% by the time it bottomed in Feb. 2009. For older investors, there may not have been enough time to recover those losses before retiring.
The precise asset allocation that works best for you will depend on your risk tolerance and how much passive income you’ll require in retirement. In general, though, financial experts recommend folks in their 60s should have a portfolio that’s around 60% stocks, 35% bonds and 5% cash.
Keep in mind that only investors who are in self-directed portfolios have to proactively rebalance. If your nest egg is invested in target-date funds, the rebalancing happens automatically as you get older — though it’s a smart practice to check in periodically to make sure you’re aware of your asset allocation.
Beyond the basic asset breakdown, rebalancing also involves reconsidering the actual investments you’re putting your money into. As you approach retirement, consider making the following changes.
Shift from growth stocks to value stocks
When it comes to rebalancing your stocks, you want to add a layer of safety and simultaneously bolster income. Value stocks can help you do that.
First, a little background: Value stocks, broadly defined, are those that are offered at a price that’s affordable given their long-term profits. They tend to grow slower and typically pay dividends. Growth stocks, on the other hand, are often expensive given their current returns but have the potential to outperform the market. They usually focus on share appreciation but typically don’t produce yield.
When you’re decades from retiring, growth stocks — like those in the tech sector — can be a central part of your portfolio, Regan says. You have the time to recover from any short-term losses, and since you’re still earning a salary, you’re not reliant on dividend distributions.
But as investors approach retirement age, that strategy should be revisited. Regan says that “if you’re going to retire and be more dependent on [passive] income, value or dividend-oriented companies that are paying you a reward for owning them tend to carry a little less risk.”
These companies often fall into recession-resistant and recession-proof sectors that provide essential goods and services, such as electricity, food, clothing and gasoline — items that people will always pay for regardless of economic conditions.
For a company whose stock falls into the value category, its size and financial health is critical, too, according to Regan. She looks for large companies that have a good amount of free cash flow. “They’re going to be fine on days when the market swings,” she says. “Tall trees withstand the forest fire.”
Diversify with ETFs
Exchange-traded funds (ETFs) are another investment vehicle that can help pre-retirees transition away from higher risk stocks. These types of funds have surged in popularity in recent years.
Nearly 90% of financial planners in a recent survey said they currently use or recommend ETFs — the most among any asset class — and 60% planned on increasing their use of the funds over the coming year.
ETFs offer a similar risk profile to stocks in that both are categorized as equities, in that both are categorized as equities and are riskier than debt securities, which include bonds and other fixed-income investments. But the benefit of owning ETFs comes down to diversification. These funds give investors exposure to multiple sectors — or multiple companies operating within a sector — thereby reducing risk compared to owning individual stocks.
The downside is that most ETFs aren’t designed to beat the market. But if you need investments that can generate considerable income in retirement beyond your fixed income sources like CDs and Social Security, then dividend-focused ETFs are “great vehicles,” Regan says.
These funds — such as the JPMorgan Equity Premium Income ETF (JEPI) — pay a higher than average yield with monthly distributions rather than quarterly payments.
Take advantage of debt securities
Beyond rebalancing your stocks and ETFs, one of the most common risk-off strategies is allocating funds away from equity securities and towards debt securities; namely bonds and CDs, as well as Treasurys issued by the U.S. government.
Because these investments have fixed interest rates, they carry significantly lower risk than stocks and provide investors with predictable returns. As you hit your 60s and approach your 70s, these investments should grow from a small pocket of your portfolio to a significant minority — representing anywhere from 30% to 40%.
On the bright side, debt securities have been producing strong yields recently, thanks to the Federal Reserve maintaining a high benchmark interest rate after a series of hikes.
However, with inflation finally nearing the Fed’s 2% target, the likelihood of interest rate cuts during the central bank’s September meeting is widely expected. Regan suggests locking in higher yields on fixed-rated instruments while they’re still around.
“You want to do that sooner rather than later, not necessarily waiting for them to cut rates,” she says. “If you do, you’re going to miss that appreciation — the total return.”
Even with cuts on the horizon, the expectation is that interest rates will remain higher than historical averages for the foreseeable future, allowing these types of investments to continue offering solid earning opportunities in the medium term.
Cash alternatives like high-yield savings accounts and money market accounts will also continue to provide strong yields, offering a safe haven for people nearing retirement despite the fact that they have variable interest rates.
The upside for cash alternatives is liquidity — your money is more accessible than with CDs or Treasurys, which cannot be accessed before maturity without incurring a penalty. “Keep three to six months worth of cash in a high interest account,” Regan says.
Rebalancing your portfolio during retirement
While it is integral to rebalance investment portfolios in the lead-up to retirement, it is equally important to revisit them once a year during retirement to help boost your income. Circumstances can change, and retirees may find themselves in need of additional income due to medical expenses, rising costs or unplanned housing changes.
Rebalancing can also further reduce your risk exposure thereby ensuring your money stretches longer into your golden years.
“Everything is pretty relative. It really depends on your spending and what cash flow you need from those investments,” Regan says. “Do we need to be a little more aggressive to keep up with spending? Or maybe vice versa, can we be more conservative?”
As much as people dislike doing it, this requires retirees to routinely revisit their household budgets to identify where expenses could be trimmed. This can help identify where portfolio rebalancing is needed and which approaches are most suitable — like maintaining the classic 60/40 allocation or shifting into a more conservative portfolio that puts at least half of your assets in fixed-interest investments and cash alternatives.
It all comes down to your budget, financial goals and personal risk, Regan says. The allocations of the retirees she works with range anywhere from 40% stocks up to 70% stocks.
“Some people think they’re going to live another 35 years in retirement, so we have to make sure that money’s going to last, and sometimes that takes a little more risk,” she says.
Consider reinvesting your required minimum distributions
Once you hit age 73, don’t forget that you’ll have to take required minimum distributions if you have a 401(k) or other employer-sponsored retirement plan, as well as a traditional IRA. These account withdrawals will affect your income and taxes.
“Most people use their RMD as a paycheck replacement,” Regan says. “If you don’t need that money, only take out what’s required and the rest is what we’re growing for the next generation.”
For those who don’t need to rely on RMDs to cover ongoing expenses, consider reinvesting those funds when you rebalance your portfolio. How you allocate that money depends on your personal circumstances and passive income goals. However, being too conservative and leaving RMDs as cash will limit the money’s growth potential and ultimately reduce how much passive income you’re generating.
Overall, there is no single way to rebalance in retirement. Instead, you want to find a personalized balance between low-risk equities and lower-risk debt securities; ideally one that will produce enough income for you to enjoy your golden years in whatever way you spent your working years dreaming about.
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