In Asset Allocation: Fixed Income (Part 1), we quickly reviewed fixed income as an asset class. We then considered fixed income allocations for Accumulators. Finally, we saw how fixed income can provide excellent diversification benefits within a portfolio. Asset correlations between, and within, asset classes, being so important.
In Part 2, how to determine a fixed income allocation for the Consolidator and Spender life cycle phases.
Fixed Income for Consolidators
Consolidators are older, but still have lengthy time horizons in which to invest. Consolidators should have some wealth accumulated and their investments in cash equivalents will reflect this. Perhaps 5-10% of total assets will be in cash.
Not the Best, But Not Bad
Because of the relatively long time frame, fixed income should not dominate the portfolio. Rather, the focus should be on investments with greater capital growth potential.
Same as with Accumulators.
Becomes Better With Age
As the time to retirement shrinks, Consolidators should increase their allocation to fixed income. This will solidify previous accumulated portfolio gains, reduce overall portfolio risk, and begin to generate stable income flows for retirement.
But not too much, as we shall see below.
The Magic Number
For the generic Consolidator, 10%-30% allocated to fixed income may be appropriate. The increase from the Accumulation phase simply reflects a reduction in necessary cash equivalents to about 5%. The suggested allocation also takes into account that Consolidators often invest in alternative asset classes.
One’s risk tolerance will determine the appropriate allocation. If you are extremely risk averse a higher percentage allocated to fixed income may be appropriate. It is your portfolio. You need to be comfortable with your investments. Because it is also your (potential) ulcer.
Finally, the extent that you invest in non-traditional investments (e.g., derivatives, commodities, venture capital, etc.) will impact your ultimate allocations.
The wider you spread your investments, the less that is usually allocated to any one class. How you diversify your portfolio will depend on your investment knowledge, comfort level, risk preferences, asset correlations, and the like.
Fixed Income for Spenders
Spenders are usually individuals at retirement age. Employment or business income has ceased and Spenders need to live on their pensions and savings.
Spenders are generally risk averse. This reflects the reduced time horizon for surviving asset volatility.
Because of this, Spenders traditionally invest primarily in fixed income and cash equivalents.
Now We Are Talking
These asset classes provide the stability, consistency, and liquidity, Spenders want.
Many Spenders invest 80-90% of their wealth in cash and fixed income.
However, the trade-off for low risk investments is a low return. And that is a problem.
Too Much of a Good Thing
Today, many people retire between 55 and 65. Yet many retirees now live until at least their 80s. That means Spenders may need to live off their savings for 25 years. Often, much more.
That is a long time to survive on investments with low returns.
With longer lives (and investment time frames), Spenders should strongly consider maintaining a portion of assets in investments with potentially higher returns.
I would suggest that investors do not allocate 80% to cash and fixed income. Keep a portion in equities and other asset classes with better expected returns.
The Magic Number
At retirement time for the generic Spender, perhaps 30%-40% in fixed income is suitable. That assumes about 10% in cash equivalents at that date.
As one continues to age, additional assets should shift into cash and fixed income instruments.
Personal factors need to be taken into account. Theses include: health situation; family history of death age; wealth accumulated; cost of living; prevailing interest rates.
If you expect to live until 110, you need to plan for that in your investing and drawdowns.
If your accumulated wealth is high, you can take a safe investment path. But if you have not saved enough for retirement, you may want or need to try and generate greater returns with riskier assets.
If interest rates are low, your level of income will also be low. If it is insufficient to cover your mandatory costs, you may also need to try to boost returns with higher risk investments.
However, higher risk means increased volatility and possibility of loss.
Where you are at retirement will play a significant role in your actual asset allocation.
Your Personal Risk Tolerance Impacts Allocations
And, as is always the case, your personal risk tolerance plays a part in the allocation. When you retire, as well as how you reallocate during your retirement years.
Most Spenders should have relatively low risk tolerance. This reflects the lack of other income on which to live and the reduced investment time frame.
But some Spenders may be extreme and want almost everything invested in safe investments. They will sacrifice some income in order to sleep well at night. Other investors with higher risk tolerances may ignore the shorter time horizon and still want a significant portion of their assets in less stable investments.
Whether you are an Accumulator, Consolidator, or Spender, one size never fits all in a specific phase of life. There may be general rules of thumb. But each allocation should be tailored expressly for your own unique circumstances.
Next up, equity allocation considerations.
