Invest, Exceed Goal, Then Stop Taking Risk

At what age should you change to a more conservative allocation, and what should that allocation look like? The answer depends on who you ask or where you look.

Target date funds, for instance, use glide paths. Over time, a glide path changes a portfolio’s allocation from being more aggressive to being more conservative. This evolution is intended to reduce the risk a person is exposed to as retirement approaches. It’s a logical approach from the standpoint of reducing the damage from a bad sequence of returns occurring near the expected retirement date. Some detractors will point out that such strategies are the most aggressive when the least amount is invested—when the investor is young, has a lower salary and is just starting to set aside money for retirement. There is relatively little money to benefit from the power of compounding. Other detractors criticize target date funds for being too aggressive at retirement or not continuing to evolve for a long enough period of time after the retirement date.

Among the alternatives to target date fund glide paths is a strategy proposed by professors at the University of Waterloo and a portfolio manager at Canadian money management firm PWL Capital. They used a fixed allocation of 60% stocks/40% bonds to demonstrate how their target wealth approach works. The portfolio is rebalanced annually to maintain the allocation. Though there is nothing new about a 60/40 allocation, what happens next is interesting: Once the wealth target is exceeded (the study’s authors suggest aiming to overshoot the target in order to reach it), the portfolio is de-risked. This occurs by allocating an amount equal to the targeted wealth to risk-free assets. This shift is not time-dependent—meaning an investor does not make the change, say, at the planned date of retirement, but rather when the goal is exceeded. In other words, you move your retirement savings out of the market once your retirement is funded.

What happens with any excess savings beyond the targeted amount? Whatever you want. You can keep investing it, buy a Mercedes, take a big vacation, set it aside for inheritance or pay for your grandkids’ college education. Since your retirement is fully funded under this strategy, any excess amount is treated as bonus money.

There are a few things to keep in mind. The underlying concepts behind this approach are not new. The 60/40 allocation has long served as a benchmark allocation. This study’s authors also are not the first—and won’t be the last—to put the money designated to fund retirement into safe assets, as opposed to equities. This study is simply combining two concepts that are often discussed apart from one another.

The far bigger characteristic of the target wealth approach is its long-term commitment. An investor would have to commit to sticking with the 60/40 allocation for at least 20 years. Such a commitment is a big hurdle given data showing many investors abandon their strategies whenever a bear market strikes.

There is a big chance of forecasting future expenses incorrectly. While such errors exist in all retirement planning strategies, in the approach discussed here, any chance for future growth in retirement savings is ended once the dollars are moved out of the market. If the investor underestimates how much monthly income is needed, a shortfall of income will occur. This risk has to be balanced against the risk of having a bear market occur at the beginning of retirement and diminishing wealth at the time withdrawals have started. A hybrid solution would involve de-risking part of the portfolio while continuing to invest the remainder for continued growth.