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How might you go about building an efficient portfolio to save for retirement?
Well, if you’re young and trying to accumulate a sum of money to support your lifestyle in retirement, the answer is somewhat simple, according to David Blanchett, the head of retirement research at PGIM DC Solutions.
“I don't want to say it's pretty easy, but you want to maximize return for some given unit of risk,” Blanchett said in a new episode of the Decoding Retirement podcast (see video above or listen below). “So that’s pretty straightforward.”
Instead of worrying about such things as asset allocation (what percent of your portfolio to invest in stocks, bonds, and cash, for instance) and asset location (what assets to put in which accounts), if you’re young, just invest your money in a target-date fund, he said.
“I'm a huge fan of target-date funds,” Blanchett said. “It's a way to simplify the decision. … So this notion of asset allocation and thinking about how to allocate across account types, that's important. But it's not a big issue for most Americans.”
As you approach retirement, however, relying on a target-date fund becomes less critical, and finding a professional to guide your investment strategy becomes increasingly important, Blanchett said. You’ll want “something more personalized,” he said. “That's where we can see a wide diversity of recommendations around risk.”
In retirement, it's a different story
If you’re in retirement, however, building an efficient portfolio becomes, in Blanchett's words, “a lot more interesting.” That’s because you have to worry about many risks, including inflation, sequence of returns risk, and longevity, or the risk of outliving your money.
Plus, if you’re retired, you want to generate income from your portfolio. “And that’s where things get tricky,” Blanchett said.
According to Blanchett, the best way to solve the trickiness of building an efficient portfolio when you’re retired is with diversification. And the optimal portfolio for one retiree is likely to be very different for another retiree.
“The optimal portfolios you might want in retirement can just look very different for each person based upon what they're trying to accomplish,” he said.
Overall, Blanchett doesn’t think retirees should invest 100% of their money in stocks — even though, on paper, it produces the greatest returns — unless they meet very certain criteria, such as being very risk tolerant or having "tons of lifetime."
He also addressed the notion that investors mistakenly view bonds as a reliable diversification asset.
According to Blanchett, there's the concept of randomness in returns, and the key takeaway is understanding how the risk of holding stocks and bonds evolves over time.
Historically, stocks fluctuate — they go up and down. However, over longer time horizons, equities tend to become less risky relative to bonds, whose risk generally increases, Blanchett said.
It’s important to note that the risk of all assets rises over time, but at different rates, he added.
And what many studies and experts, Blanchett included, have pointed out is that stocks, in the long run, become more appealing. Even individuals who are risk-averse and uncomfortable with market volatility may find that leaving their portfolio untouched often yields better results with a more aggressive allocation to equities rather than bonds, he said.
Meetings and book deals at the Hachette book trade stand during the third and final day of the London Book Fair at the Olympia Exhibition Hall, on March 14, 2024, in London, England. (Richard Baker / In Pictures via Getty Images) ·Richard Baker via Getty Images
At the same time, another key objective for retirees is to increase their after-tax rate of return as they save for and live in retirement. For some, this could mean allocating bonds (which tend to be tax-inefficient) to pre-tax accounts and stocks (which tend to be tax-efficient) to taxable and Roth accounts as a strategy to enhance their long-term rate of return.
If you have a traditional IRA, a Roth IRA, and a taxable account, and all of them are invested in the exact same way, you are missing an opportunity to optimize your after-tax returns.
“There’s extremes you could take it to,” Blanchett said. But you should focus first on determining the appropriate level of risk for your assets, and then consider how to integrate tax strategies to further enhance the after-tax rate of return.
Blanchett also addressed the hardest aspect of retirement planning: knowing how long you might live and, therefore, knowing how long you will need your money to last.
“The problem is that uncertainty of how long you're going to live,” he said. “It just radically complicates what we're supposed to do and how much you're supposed to save.”
According to Blanchett, the shift toward defined contribution plans hasn’t been entirely beneficial for Americans. That’s because when people reach retirement, it’s difficult to create a plan that accounts for various idiosyncratic risks, such as longevity.
“It’s a huge issue,” he said.
Blanchett said one of the best strategies to address the longevity issue is to delay claiming Social Security or purchase a lifetime income annuity. This matters especially for individuals in the top income brackets who tend to live three to five years longer than the average American.
If you don’t accurately assess your longevity, if you don’t “personalize your plan,” there’s a real risk that you’re not “preparing for the appropriate potential length of retirement,” Blanchett said.
Many financial advisers today commonly recommend planning for a lifespan of up to age 95 to ensure clients can maintain their desired standard of living throughout retirement. Blanchett said planning to age 95 is a good starting place. But for some couples aged 65, there’s a 50% chance that one will live longer than age 95.
