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How Pre-Retirees Should Be Thinking About 401(k) Allocation in 2020

By Ryan Downie – Oct 3, 2020 at 1:35PM

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Retirement planning is difficult in today's environment, but following key principles can help investors manage their 401(k) with confidence.

2020 has been a turbulent year in the global economy, the stock market, and life in general. It's an unprecedented, intimidating environment for anyone planning for retirement, and it requires special attention to avoid devastating pitfalls that can wipe out years of hard work, diligent saving, and prudent investing. Adhering to several core principles and avoiding emotional decision-making in favor of a scientific approach can transform investors' golden years.

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Retirees need to understand the major investment risks and how a 401(k) fits into their overall financial plan. In retirement, assets' primary function is to replace the earned income that fueled a household before retirement. Interest and dividends from securities become the primary sources of cash flow, along with distributions from accumulated investments. Successful retirement strategies must address volatility, inflation, interest rates, longevity, and taxation for 401(k) assets.

Take steps to limit downside volatility risk

Volatility is the most obvious risk to 401(k) accounts while entering retirement. If you happen to retire shortly before or after a market crash, your assets likely won't have enough time to recover before withdrawals are made. Withdrawals in a down market lock in losses that can hurt your retirement lifestyle.

Retirees have short investment time horizons, and volatility must be limited as capital preservation is prioritized. Retirees' 401(k) allocations should shift away from volatile assets toward holdings that have more stable returns. This is commonly accomplished by rotating away from stocks toward bonds.

The traditional rule of thumb for equity weighting in a 401(k) has been to take 100 and subtract the person's age, meaning a 65-year-old's 401(k) would consist of approximately 35% stocks and 65% bonds. This exact approach is the subject of debate in this article, but it's a useful example of evolving asset allocation. Reduced volatility can also be accomplished by reallocating within equity holdings to more stable positions -- for example, by selling high-growth small-cap stocks and buying large, mature dividend payers.

Soaring stock valuations, a contentious presidential election, and global economic weakness are likely to create near-term volatility and downside risk, so these considerations are extremely salient right now.

Taking other risks off the table

Unfortunately, retirement asset planning is more complicated than replacing all of a portfolio's stocks with bonds. Equities cannot be abandoned entirely, because growth is still required to get through the later years of retirement. Inflation erodes buying power each year, so a dollar may only go 80% as far a decade from now. Stock prices generally rise over time with the prices of consumer goods, making them an accepted form of protection against inflation risk. As a result, 401(k) accounts still need equity exposure, even if a retiree has already begun making withdrawals.

Interest rate risk is also relevant today. Investors who rely on income from bond interest obviously depend on the rates yielded by those bonds. Rates that fall too low affect a retiree's ability to pay bills and live the life they've planned. Interest rates are near historical lows in 2020 with the Fed indicating its willingness to keep things this way for as long as necessary to support the economy. Rates may not have much further to fall, but risk mitigation can still be accomplished with diversified bond maturity dates. Some asset managers have also turned to dividend income within their equity holdings to provide more income, though this could negatively affect growth down the road.

Use 401(k) savings in the context of an overall plan

Retirees should know how and when 401(k) assets are going to be withdrawn in relation to other assets. Recommended annual withdrawal rates have typically been 4% to 5% historically, but this benchmark is being challenged as low interest rates threaten the sustainability of that math. Taking out too much too soon can deplete a 401(k) prematurely.

Longevity risk is a genuine concern, and married couples must ensure that neither spouse outlives their savings. Annuities were designed specifically to transfer longevity risk from the account holder to an insurance company, and 401(k) accounts can be rolled over without penalty to qualifying annuities. However, these are hotly debated topics due to associated fees and investment rigidity, so not all investors are comfortable using annuities. For those bearing the full weight of longevity risk, it's important to keep withdrawal rates sustainably low with some portion of the 401(k) exposed to equity growth.

Taxation must also be considered when sourcing funds for living expenses. Traditional 401(k) withdrawals are taxed as ordinary income in retirement, whereas funds from other sources are likely subject to capital gains. Retirees anticipating that income tax rates will rise in the future might consider accessing 401(k) funds sooner rather than later. Alternatively, investors who can utilize strategies such as tax loss harvesting in their brokerage accounts might advantageously source funds from there. The correct approach varies among situations, but withdrawal strategies need to consider different tax treatment now and over time.

Sticking to a full slate of risk management principles will help ensure smooth sailing for 401(k) holders in retirement.

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