Mailbag: Asset Allocation Decisions

Here is the latest roundup of your questions and my (brief) answer. In what should be a familiar excuse by now, I just don't have the time to answer all your question in the detail they deserve, so I will definitely be taking shortcuts. All of your questions this time around happen to be about asset allocation decisions. Here we go...


1. Reader Question

Hi, Thanks for the blog and your insight. I am rebalancing my 401k and I am looking to follow your advice to choose funds with low fees. At the moment I have all of my money in RRTDX (T. Rowe Price Retirement 2040 R) which has an expense ratio of 1.29%. I like the automatic nature of these target date funds but the expense ratio is just too high, so I want to go to different funds to drop this expense ratio by at least 0.5%. My company has a spread of funds and I want to mimic the asset allocation of a target date fund across the lower fee ETF type funds offered. I will then rebalance each year as a target date fund does. But I do not know the best allocation for me. I'll be about retirement age in 2040 so I'll follow the allocation pattern for 2040 target date funds. What is a good asset allocation that will mimic a 2040 target date fund? 20% Bonds 60% Domestic Equities 20% Foreign Equities How to then rebalance this each year to mimic a 2040 target date fund? Add 1% to bonds and drop 1% from domestic/foreign equities in alternating years? Below are the lowest expense ratio funds available in my 401k plan (these are all under 1%, all other funds are actively managed and over 1%). The funds have no ticker. Suggestions on an allocation?
1) SSgA Cash Series U.S. Government Fund - Class L
2) SSgA U.S. Inflation Protected Bond Index NonLending Series Fund - Class G
3) SSgA Aggressive Strategic Balanced Securities Lending Series Fund - Class VII
4) SSgA Conservative Strategic Balanced Securities Lending Series Fund - Class VII
5) SSgA Moderate Strategic Balanced Securities Lending Series Fund - Class VII
6) SSgA S&P 500 Index Securities Lending Series Fund - Class IX
7) SSgA S&P MidCap Index Non-Lending Series Fund - Class J
8) SSgA Russell Small Cap Index Securities Lending Series Fund - Class VIII
9) SSgA International Index Securities Lending Series Fund -Class VIII
10) SSgA REIT Index Non-Lending Series Fund - Class G
Thanks for any input.

My Reply

There is no single "right" asset allocation for 2040 target retirement date. All fund companies, my favorite Vanguard included, are more or less winging it -- including making changes to the asset allocations mid-flight. So I would absolutely not try to duplicate some specific target retirement fund's asset allocation, but instead think what asset allocation is right for me. Only you can answer that question, but I try to suggest some ways of doing that on this blog. The single most relevant post I have on this subject is probably How To Select Investing Strategy.

The 60% US, 20% international, 20% bonds that you mentioned is a perfectly good choice if you are young and are willing to put up with substantial declines in the value of your holdings every, say, 5-10 years. I prefer a bit higher international allocation but what you wrote is fine as well.

Of the funds you listed, unfortunately it's hard to make recommendations without knowing expense ratios. That "SSgA Aggressive Strategic Balanced Securities Lending Series Fund" probably comes close to your 60/20/20 breakdown, but if it charges a big premium for the privilege, I would pass on it. You can maintain that balance yourself using something like 45% SSgA S&P 500, 10% SSgA S&P MidCap, 5% SSgA Russell Small Cap, 20%  SSgA International, and 20% mix of cash and inflation-protected bond funds (both of which, unfortunately, are likely to be lousy).

This is about as good advice as I can give without knowing expense ratios. If all of the funds you listed have identical, say, 0.40% expense ratio, then I would probably go with one (or two, to get the desired ratio) of the auto-rebalancing aggressive/moderate/conservative funds. If those charge extra, then I would do a DIY mix using the others.


2. Reader Question

Hello, We have recently retired and are now in the draw-down phase. I am struggling with establishing my basic stock/bond mix due to the bond dilemma. I know all the guidelines and have completed endless risk tolerance profiles. They all conform to my own risk tolerance assessment which is low risk. That means a higher allocation to bonds. However, between their low returns and increasing interest rate risk, bond funds look riskier than stocks for years to come. So the conventional wisdom seems turned on its head in that I'm being advised to increase my allocation to so-called “safer” bond funds. Am I not increasing my risk by allocating more to bonds ?

My Reply

It's a very good question to which, unfortunately there is no good answer. Yes, there are dangers with both stocks and bonds, just as you said. Stocks can (and will, sooner or later) have steep bear markets where they might lose a third or half or even more of their value in a terrifying year or two. Bonds will never have similar plunges, but over time they may only barely keep up with inflation -- if that -- the way they are priced now. That's just the reality of the market. I would not go into either extreme but have a balanced mix of both stocks and bonds, making sure to invest in both at lowest possible cost because costs is the one very important thing you can control. And I would not expect historically average returns from either stocks or bonds. Bonds are more or less doomed to mediocrity for awhile. Stocks have a shot at historically average returns, but I would not count on them. It's better to be pleasantly surprised than to be bitterly disappointed.

Having said that, you are still likely be far better off investing in a mix of stocks and bonds than sitting in cash and waiting for a crash to buy everything cheap. Pick your balanced mix of stocks and bonds and stick with it. As I mentioned above, my post How To Select Investing Strategy tries to give you some guidelines on selecting a specific mix. If your portfolio is substantial relative to your living expenses over and above any pensions and Social Security (say, 30 times bigger or more), then even a bond-heavy portfolio (say, 25% stocks + 75% bonds) is very likely to be adequate for a long secure retirement.

Also, with a bit of shopping around you can probably improve on bonds by using CDs instead. For example, PenFed CDs offer both higher yields and better safety than Vanguard's total bond market fund. In addition PenFed (and some other banks too) give you the option to break a CD early for a relatively small penalty in case interest rates rise unexpectedly soon. In that scenario a bond or bond fund would drop in price, making breaking a CD and immediately re-investing at more attractive rates a very nice option to have.

By the way, don't be afraid of rising interest rates -- look forward to them. Vast majority of today's bond investors should be welcoming rising interest rates, not running away from them. The small temporary drop in bonds' values will be more than offset by higher yields that come with rising interest rates. Only if you are quite old or are locked into very long maturities, should you worry about rising interest rates. If you are, say, 65 years old and are invested in Vanguard Total Bond Market fund, then rising interest are much more likely to be your friend than your enemy, even if initially they cause a dip in existing bonds' value. If you are younger (or invested in short-term bonds) then it's even easier to look forward to rising interest rates.


3. Reader Question

Hello, We just retired and need some help setting our nestegg. Would appreciate any advice.
1. I'm 59 years old, wife 57. We own our home and have no debt.We would like about $60K - $75K / year retirement income
2. I receive a pension of $21K per year with no cost of living adjustment
3. Have $ 700K in a 401K’s, IRA’s and Roth invested in Stable Value.
4. Have $1 million (taxable) that is invested in 10% each in TSM & TBM, balance in online savings accounts, and money market.
5. Plan to take Social Security at 62. Wife 70.
6.Our current expenses run 42K/yr for modest lifestyle.
7.I am low to moderate risk tolerance based on questionnaires and prior history in 2002 and 2008.
Thanks. Your blog is great !

My Reply

Thanks for writing. You didn't mention the size of your eventual Social Security payouts, but assuming that combined your and your wife's Social Security payments will total at least $30,000 (which seems very likely) you should have absolutely no problems funding a long and comfortable retirement. There is a good chance of success even if combined Social Security payments are much smaller.

You could plan for a 40-year retirement. It's a bit optimistic, but optimism is the way to go here. Before taxes you will need to withdraw about $85K/year before taxes to start with and increase that amount with inflation in subsequent years. Your non-inflation adjusted pension will contribute $20K in the beginning, but towards the end of your 40-year plan it will only be worth about $5K in today's dollars. In other words, you will need your investments to cover around $65K/year in the beginning and $80K towards the end (again, in today's dollars). You have $1.7M investable assets. Safe annual withdrawal rate with very high confidence of it lasting 40 years is somewhere in 3% range. That lets you start with spending about $50K a year (which will grow with inflation) from your portfolio with very high confidence of your portfolio's lasting full 40 years.

Adding that up it means you will need to withdraw extra $15K/year in addition to our "safe" $50K withdrawals for 3 years until your Social Security kicks in. Then another 10 years until your wife's Social Security kicks in. Even assuming both yours and your wife's eventual Social Security payouts will be modest $15,000 a year and allowing for some inflation (that eats into the portion contributed by your non-COLA pension) that still leaves you only needing around $100K over the next 13 years over and above the annual "safe" $50K withdrawal and your Social Security payouts. That's really just a rounding error, given the size of your portfolio. After the 13 years, both of you will be getting COLA'd $30K in Social Security plus your non-COLA pension, plus $50K safe withdrawals from the portfolio easily putting you at or above the $85K/year pre-tax income.

Even with very conservative Social Security payout assumptions you should have no problems funding a 40-year retirement. The only thing I would suggest is to up equities slightly -- to maybe 20-30% of your entire $1.7M portfolio, from about 6% that you have now. Even your present 6% in stocks has a good chance of being enough -- especially if your Social Security payouts are higher than the low $30K I assumed -- but historically having 20-30% stock allocation actually increased both the safety and the growth of your portfolio compared to 100% or nearly 100% in bonds. I expect that to continue in the future as bonds are clearly on the expensive side, while stocks may or may not be. I would not recommend dropping below 20% in equities for most people. Of course you should go with maximum diversification and lowest available cost for all your investments and Vanguard is usually the best choice to accomplish that.

If your combined Social Security happens to be truly tiny -- say, $10K combined -- then you could go with combination of slightly lower living expenses (closer to your $60K target instead of $75K) and slightly higher withdrawals from your portfolio. You could also look into annuitization as a solution to longevity risk.

Bottom line, you are in very good shape financially. It's very likely that any asset allocation will suffice for you, but I would aim for a bit more in stocks then you have now -- $350-500K total in stocks out of your $1.7M in investable assets. If your combined Social Security payouts are much lower than the $30K it's probably worth to look into annuitization for a part of your assets.


4. Reader Question

Dear LTR, Fantastic blog/website! Knowledgeable, clear, concise and well written! A great resource! Question: After much tinkering and analysis, I have returned to simplicity and decided on a 50/50 Equity/fixed income portfolio allocation. The equity side is globally diverse (VTI/VXUS/VWO and their equivalents at rock bottom ER's) in both taxable and non-taxable accounts. For the FI side, I have decided on 25% cash (I-bonds annual max. and "high" yield credit union savings) in my taxable accounts, functioning also as a long term emergency fund. The dilemma, of course is the remaining 25% given the current yields and high prices of this 30 yr. bond bull market. I have plenty of space to accommodate the remaining 25% allocation in non-taxable accounts. If one wanted to keep durations very short, would it make any sense to invest the remaining FI allocation in VTIP? I realize that the current real interest rate on this short duration VG tips fund is negative (SEC -1.35 as of this writing), but there would still be inflation protection and not much risk in rising real interest rates, yes? I am weighing this against an investment in short/intermediate term nominal bonds (SHY, 5yr treasuries/Total Bond etc....) and viewing VTIP as an imperfect extension and addition to I-Bonds once the max contribution to those is purchased. Also, given the negative real interest rate of VTIP, is there less of a concern in holding some of this allocation in a taxable account contrary to conventional guidance relative to TIPS location? The total portfolio is in the mid six figures. Your guidance and thoughts will be greatly appreciated!

My Reply

Thank you for the kind words about my blog. Based on what you wrote I think you understand all the issues involved very well. VTIP is certainly a very safe choice, in terms of both interest rate risk (due to its short duration/maturity) and, of course, credit risk. But what you are getting in return for that safety is return that's most likely will trail behind any of those "high" yield savings for the next couple of years. The expected return from short TIPS like VTIP is about the same as the YTM of nominal treasuries of the same maturity, which today stands at below 0.30%. Such low returns do mean, as you said, that it's acceptable to hold VTIP in taxable space for now. But I would view it not as a positive of new-found flexibility but as a negative reflecting VTIP's poor returns.

Instead of VTIP I would take a few hours to find and invest in some FDIC-insured 1-2% 2-3 year CDs with option to break early (e.g. PenFed), in either IRA or taxable and/or "high-yield" savings accounts in taxable. In my opinion it's very unlikely that these choices trail VTIP returns over the next 2-3 years (average maturity of VTIP holdings), while providing equivalent safety from default and better safety from rising interest rates. You might be able to squeeze an extra 1% a year from your fixed income this way for the next couple of years.

In 2-3 years (or maybe sooner if interest rates rise unexpectedly) you can re-evaluate. There is just no reason to commit to VTIP now, unless you simply wish to make it your permanent holding for life and completely tune out of managing your portfolio.