Sunday, March 11, 2007

Determining an Asset Allocation in Retirement

As an investor approaches retirement age, the amount of investment funds available to them is a critical issue. Once an acceptable asset level is reached, entering retirement certainly seems to become a reality. Once retired a retiree does not want his or her investment assets exposed to significant declines due to downside investment market volatility.

The public portion of the American Association of Individual Investors' website contains an article, Retiree Stock Allocation Recommendations: Do You Fit the "Mold"? by William Reichenstein, CFA. The article discusses the differences in asset allocation recommendations among the various "lifestyle" type mutual funds from fund families like Vanguard, T. Rowe Price, to name a few. The recommended allocation to stocks ranges from 20% to 40% for retirees of the same age. An excerpt from the article notes:
Why the differences?

The recommendations for a 20% stock allocation most likely come from evidence from historical returns indicating that portfolios containing these stock exposures have a risk that is no higher than an all-bond portfolio, a risk level that is appropriate for a shorter-term time horizon.

The higher recommended stock allocations most likely are based on studies concerning withdrawal rates during retirement.

For example, one recent study found that, for individuals withdrawing funds each year from their portfolio, the probability of not outliving retirement resources was maximized when initial withdrawal rates were kept below 5% (with subsequent withdrawals increasing with inflation). For a 4.5% initial withdrawal rate, the probability was maximized with portfolios consisting of 40% stocks and 60% fixed income (including both bonds and cash) over a 30-year time horizon, while for a 4% initial withdrawal rate, the probability is maximized with an allocation of 30% stocks and 70% fixed income. [For a complete description of this study, see "Bear Market Strategies: Watch the Spending, Hold the Stocks," a study by T. Rowe Price, in the May 2003 AAII Journal].

So, who should you believe—the 20% crowd or the 35% to 40% crowd?
A retiree's/investor's allocation to stocks/bonds/cash depends on a number of factors. The article provides a cursory review of some of these factors, for example, time horizon, asset levels, withdrawal rates, and a retiree's health.

Lastly, a brief analysis is provided regarding international diversification and the potential drag on returns that cash can create over longer periods of time.

Retiree Stock Allocation Recommendations: Do You Fit the "Mold"?
American Association of Individual Investors
By: William Reichenstein, CFA

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