Rethinking bond allocation as you approach retirement

The traditional stock-bond rules for retirement are changing

For decades, retirement investors followed simple rules of thumb for asset allocation. Some advisors recommended subtracting your age from 100 for stock exposure. Others promoted a classic 60/40 portfolio made up of 60% stocks and 40% bonds. Those rules were designed to make investing easier. The problem is that retirement planning has become more complex. Plus, two major changes in recent years have led many to rethink the rules around bond allocation, and how conservative vs. growth-oriented your asset allocation should be at different stages of your life.

Change one: We’re all living longer

One of the biggest reasons traditional asset allocation rules deserve a second look is that retirement itself has changed. Most of the current advice floating around was designed a generation ago when a retirement was expected to last 15 to 20 years. Today, it’s increasingly common for retirement to last 30 years or more as we live longer, healthier lives. That’s great news in most ways, but it creates a new challenge for investors.

The longer your retirement, the longer your portfolio may need to support your spending. Being too conservative with your bond allocation early in retirement can stifle the growth you may need to continue to live comfortably well into your 80s and perhaps even beyond.

Change two: Inflation and interest rates have become more volatile

Most bonds pay a fixed interest rate and fixed return at maturity. When inflation is higher, it eats into your real return. For example, a 5% yield bond during a period with 1% inflation has a real return of 4%. But if inflation jumps up to 3%, then that real return shrinks to only 2%. Treasury inflation-protected securities (TIPS) try to adjust for this and have become increasingly desirable.

On top of that, interest rates often rise when inflation does, and that typically causes the market value of existing bonds to fall on the secondary market. That’s because newly issued bonds may offer higher yields, making older bonds less attractive by comparison. Bonds with longer durations experience these effects even worse.

Because of these two developments, and retirement planning getting more sophisticated overall, the question is no longer, "How much should I have in stocks versus bonds?" Instead, investors need to ask, "How can my portfolio help support the income I’ll need throughout retirement?"

The shift from growing your money to funding income

During your working years, investing is largely about accumulation. You’re contributing to retirement accounts, building savings, and giving your investments time to grow. Short-term market declines can be frustrating, but as long as you have a diversified investment portfolio, they may matter less when retirement is still decades away. There’s time to recover.

As retirement approaches, that objective begins to change. Instead of focusing solely on growing your portfolio, you begin to think about how to make it last. Changing to a higher bond allocation has traditionally been about safety—making sure you don’t lose wealth in your retirement portfolio if there is a market downturn. However, today there are arguably smarter ways to protect yourself in the short term while still allowing more of your savings to stay in “growth” mode, leading to your money working harder and potentially lasting longer. In reality, today it’s all about time horizons. If you don’t need to access a certain chunk of money for 15 years, you can often afford to keep it in growth assets based on historical data. This article will explain how to separate immediate needs from longer-term needs in a later section.

What does “too aggressive” or “too conservative” really mean?

A portfolio with too much stock exposure may experience larger year-to-year swings in value. This often means little when you’re saving in your 30s, because historically the market always recovers. However, if this happens just as you are retiring, it can have a large effect. If you don’t have more stable buckets to pull from, you risk locking in losses, and that can have a compounding effect on the longevity of your savings.

On the other side, an overly conservative portfolio may not generate enough growth to keep up with inflation or support a retirement that lasts 20, 30, or more years, as life expectancies continue to increase. That’s why there is no universal definition of "too aggressive" or "too conservative." The right allocation depends on your spending needs, other sources of income, time horizon, and personal tolerance for risk. A portfolio that feels appropriate for one retiree may be completely wrong for another.

The problem with a one-size-fits-all asset allocation

Rules of thumb became popular because they are simple. They provide an easy answer to a complicated question and can offer a useful starting point for investors who don’t know where to begin. But everyone is different. Even people of a similar age, with similar savings, may need very different strategies. And it’s not just about advice. Outdated age-based rules pop up in other places as well. They often form the basis of retirement calculators and even appear in target-date mutual funds, often the default selection in many 401(k)s.

Age-based asset allocations

Rules such as "100 minus your age" or "hold your age in bonds" attempt to reduce risk by increasing bond exposure as investors get older. While these approaches are easy to understand, age alone doesn’t determine how much risk an investor should take, and this approach misses a lot of details.

The 60-40, 40-40-20, and 25-25-25-25 portfolios

Diversified model portfolios have long been used to balance growth and risk. The traditional 60/40 portfolio remains one of the most well-known examples, while newer variations spread investments across additional asset classes.

These strategies can provide a useful framework, but they share a common limitation: They focus on percentages rather than people. A portfolio allocation that works well for one retiree may be poorly suited to another.

Warren Buffett’s 90/10 rule

One of the most widely quoted asset allocation strategies comes from Warren Buffett, who has suggested that many investors may be well served by a portfolio consisting of 90% index stocks and 10% short-term government bonds. This is considered a much more aggressive approach than others, and it assumes investors can tolerate significant market volatility and remain invested through periods of decline.

Pros and cons of bond allocation in retirement

While the rules are changing, bonds continue to play an important role in retirement portfolios. They can provide income and help reduce volatility, but they also come with tradeoffs that investors should understand before deciding how much of their portfolio to allocate to bonds.

Pro: more than just the ‘safe’ side of your retirement portfolio

Many people think of bonds as the safer alternative to stocks. While bonds can help reduce portfolio volatility, they can also serve several other important purposes in retirement. Bonds can provide a relatively predictable stream of interest payments, and when paired with the right bond ladder, staggered mature dates can also serve as a source of liquid funds from year to year. In other words, bonds aren’t just there to make a portfolio more conservative. They can help create stability while providing income and liquidity.

Pro: bonds can help protect against bad timing

One of the biggest risks retirees face isn’t necessarily poor market performance. It’s poor market performance at the wrong time. A significant stock market decline early in retirement can be especially damaging when you’re withdrawing money to cover living expenses. Selling stocks during a downturn can lock in losses and leave less money available to participate in a future recovery. This is often called sequence-of-returns risk, and bonds can help provide a bridge when money is needed but the market is poor.

Con: interest rates and duration can affect bond yields

Interest-rate risk can be a real challenge, particularly as rates become more volatile. When interest rates rise, newly issued bonds often offer higher yields. As a result, older bonds paying lower rates may become less attractive, causing their market value to fall. The longer it takes for a bond to mature, the more sensitive it tends to be to changes in interest rates.

Con: bonds can limit long-term growth

The tradeoff of stability is that bonds historically don’t earn as much as stocks and other assets. A bond might typically return 3% to 5%, and when inflation is calculated, the real return is even lower. A low-expense index fund can average a return closer to 9%–10%. That compounding difference can be huge over time.

A note on individual bonds vs. bond funds

Individual bonds and bond funds can both play a role in a retirement portfolio, but they work differently. Individual bonds have a set maturity date and are very predictable. Bond mutual funds and exchange-traded funds (ETFs) can often be sold or purchased at will, and can offer diversification and some liquidity, but their value may fluctuate with market conditions.

A more thoughtful approach: the bucket strategy

If traditional stock-bond allocation rules don’t tell the whole story, what should investors focus on instead? One increasingly popular approach is the bucket strategy. Rather than organizing your retirement portfolio around a specific percentage of stocks and bonds, the bucket strategy organizes assets based on when you’ll need the money. The goal is simple: Use more stable investments, including bonds, for near-term spending needs and reserve growth-oriented investments for expenses that may be years or decades away.

A typical bucket strategy might look something like this: