If you are a participant in a 401(k) plan, you may have received a notification from the plan administrator indicating that you may be too heavily allocated in stock for your age.
Balancing investment risk can be challenging, especially when the answer does not seem so clear cut. One thing is true, though: Risk is a certainty when it comes to investing. The question is, “Which risk is riskiest?”
There are two risks that most investors focus on: market risk (usually stock related) and interest rate risk (usually bond related). And many subscribe to the old adage — stocks are for the youth and bonds are for the old. But that’s no longer appropriate in today’s world.
(MORE: 8 Ways to Derail Your Retirement)
The Biggest Risk of All
This is not your parents’ retirement, when life expectancy was much shorter and retirees spent only seven to 10 years in retirement.
Increasing life expectancy presents the third, and biggest risk of all: longevity risk.
As a financial adviser, I believe longevity risk (the risk of outliving your money), is the biggest reason why pre-retirees and retirees should consider having more stock in their retirement allocations.
It’s worth remembering that, stocks have historically outperformed bonds over the long-term (and helped investors stay ahead of inflation).
Take for instance the period between 1981 and this summer. In 1981, when people first began investing in 401(k) plans, the Dow closed the year at 875. On July 25, 2014, it closed at 16,960; an 1,800 percent increase. Conversely, the 10-year bond yield was 15 percent in 1981 and today is around 2.5 percent.
During this same time period, advances in medicine and healthy living have allowed for increasing life expectancy.
(MORE: Put Your 401(k) to the Test)
How Retirement Changes Enter the Picture
Retirement trends are changing, too.
Many people are choosing to retire later because they enjoy working and being engaged; the Full Retirement Age for collecting Social Security benefits has been raised to 67 for those born after 1960. And since Americans are living healthier lives, generally, many retirees are spending two to three decades in retirement — that’s a perfect scenario for inflationary pressures to present a real risk to their purchasing power.
Your time horizon is one of the most important factors to consider when selecting an asset allocation mix, so you’ll want to link your allocation to your goals and to when you expect to use the funds.
(MORE: 5 Money Pitfalls of Pre-Retirees)
A Tale of Two Preretiree Investors
Consider these two scenarios:
An unmarried investor, age 61, expects to work until 70 and receive a pension and Social Security that will equal her living expenses. She has a nine-year time horizon until her retirement target date. But she also expects her investments won’t be used for income in retirement. Instead, that money will go towards annual gifting, medical costs and inheritance. This extends her investing time horizon even further. She should consider a 70 percent stock/30 percent bond allocation.
A married couple, age 64 and 63, plan to retire at 66 with Social Security income that will cover a third of their living expenses and a $750,000 investment portfolio. The portfolio will distribute monthly income to supplement their Social Security. Since this couple has a shorter time horizon and plans to use all their investments for income, their portfolio allocation should hold a smaller percentage in equities, but still have an equity allocation.
5 Questions to Ask
Ask yourself these five questions before you choose your investment allocation:
1. Am I choosing an allocation based on my age or my time horizon?
2. When do I expect to use my investments?
3. Does my allocation mix take into consideration when I will use these funds?
4. Am I chasing returns by selecting investments based only on their track record and not how well they fit my time horizon?
5. Am I investing with age 60 in mind — or age 80?
Age is just one factor in determining an appropriate asset allocation. Just because you’re 60, that doesn’t mean it’s time to sell all your stock.
With longer life expectancies leading to longer retirement periods, having an allocation in stocks may be an appropriate choice for your retirement plan. Be sure to review your asset mix annually and to adjust when your time horizon objectives change.
Securities offered through FSC Securities Corporation, member of FINRA/SIPC. Brennan Financial Services is not affiliated with FSC Securities Corporation or registered as a broker-dealer or investment advisor. Investment advisory services offered through Brennan Wealth Advisors, LLC, a registered investment advisor not affiliated with FSC Securities Corporation. The Dow Jones Industrial Average is an unmanaged index which consists of a price-weighted average of 30 significant stocks traded on the New York Stock Exchange and the Nasdaq and cannot be invested in directly. No investment strategy, including diversification, asset allocation and rebalancing, can guarantee a profit or protect against loss. Past performance is not a guarantee of future results. This article is intended for informational purposes only and should only be relied upon when coordinated with individual professional advice.