Guidance

RESOURCES TO HELP SHAPE YOUR FINANCIAL FUTURE

Numerous studies have delved into the topic of whether rebalancing a portfolio—periodically trimming appreciated securities and plowing money into those that have not performed as well—helps improve its risk/reward profile. Most of that research points to there being a clear benefit in risk reduction, but less so for returns enhancement. That is an intuitive conclusion. After all, the standard method of rebalancing—moving money from stocks to bonds and vice versa—will tend to scale back on stocks over time as they outperform bonds over longer time horizons. That reduces volatility but does not help on the returns front relative to a portfolio whose equity allocation drifts ever higher.

Yet, some may argue that how much value you place on rebalancing depends completely on life stage. Most younger investors do not worry too much about controlling risk in their portfolios; generating returns is where it is at. For them, periodically reducing risk through rebalancing falls into the category of “nice to have,” but it is not mission-critical. Making regular contributions and maintaining an equity-heavy mix through volatile market conditions will tend to be far more impactful. Indeed, many accumulators who took a hands-off approach to their portfolios might be inclined to stick with a similarly laissez-faire approach through retirement.

But the utility of rebalancing shoots up in retirement, in ways that are not typically discussed as much. Of course, rebalancing is beneficial from a risk-reduction standpoint, and risk reduction is arguably even more important in retirement than during accumulation. But rebalancing also brings multiple additional benefits. Cash flow sourcing is at the top of the list, as it is increasingly important in the current era of ultra low yields. Rebalancing can also help with diversification, taxes, and charitable giving.

Here is a closer look at the virtues of making rebalancing part of your retirement portfolio plan—as well as a bit of detail about how to do it.

Reason 1: It can help you source cash flows.
Times are hard for retirees who were hoping to subsist on whatever income their portfolios kick off. One effect of the Federal Reserve’s actions to head off an even worse economic disaster has been that yields on cash and other safe securities have dropped dramatically. Dividend yields on equities have held up better, but there have been dividend cuts there, too, especially in the financials, energy, retail, and leisure sectors.

This is partially why rebalancing can be so helpful in retirement—it broadens your horizons beyond current income. If your portfolio’s yield comes up short in a given year, you can turn to rebalancing to help make up the difference. Of course, there will be years when appreciation and rebalancing opportunities are scant, and yields are also underwhelming. The year 2018 comes to mind, and 2020 may well be another. This is why some advise that retirees also maintain cash reserves to help them salvage their cash flows and maintain their standard of living in those lean years. But in many other market environments, the combination of current income and rebalancing proceeds provides a terrific, well-diversified cash flow engine.

Reason 2: It can help you build a better-diversified portfolio that is not overly reliant on current income.
In addition to helping to diversify your cash flows, a retirement portfolio strategy that encompasses rebalancing can help you build a better-diversified portfolio, period, versus one that focuses on yield-rich sectors alone. We have seen in 2020 that many higher-yielding investment types can also be economically sensitive. Because of that, and related dividend cuts resulting from tough business conditions, dividend payers have experienced a tough campaign so far this year.

At the same time, securities with underwhelming yields—notably technology stocks and Treasury bonds—have been pacing the market and could potentially be trimmed via rebalancing to help meet living expenses. That is not to say you should exclude yield-rich securities from your retirement portfolio altogether, but you may consider embedding them alongside non-dividend-payers for a smoother overall ride.

Reason 3: It can help you manage your portfolio’s risk levels and stick with your asset-allocation plan.
This gets back to the big benefit of rebalancing regardless of life stage: It can help ensure that you maintain your portfolio’s risk and allocation levels on an ongoing basis. Volatility control is especially valuable to retirees, who have no choice but to draw upon their portfolios for living expenses no matter what the economic environment.

Market action in 2020 provides a great example of how powerful rebalancing can be from that standpoint. Of course, few people saw a pandemic coming last year, along with its related economic and market dislocations. But coming off of 2019’s monster equity-market rally, investors adhering to a disciplined rebalancing regimen would have been trimming stocks and using them for 2020 living expenses and/or adding them to bond holdings.

Reason 4: It can help you meet your tax obligations.
Retirees should do a single, once-annual checkup of their portfolios. At that time, they can check their portfolio’s allocations relative to their targets and determine whether rebalancing is in order. And retirees who are age 72 and above and therefore subject to required minimum distributions from their tax-deferred accounts can also tie their RMD-taking into the rebalancing process. (Note that RMDs are suspended in most cases for 2020, but they are likely to be back in effect in 2021.)

Specifically, retirees can source their RMDs from those holdings they wanted to scale back on anyway. They can steer them into their taxable cash accounts for the year ahead, or if the RMDs exceed their cash flow needs, redeploy them into whichever assets need topping up in their taxable accounts. (They could even steer the rebalancing proceeds into a Roth IRA, provided they have enough earned income to cover the amount of the contribution.) In so doing, they fulfill their tax obligations while also improving their portfolios and/or sourcing cash flows.

Reason 5: It can assist with charitable giving.
Relatedly, rebalancing can also serve as the source of funds for charitable giving, simultaneously satisfying a retiree’s charitable goals and earning a tax break while also helping to improve the portfolio. If a retiree wants to make rebalancing-related adjustments to his or her taxable account, those appreciated positions can be donated directly to charity or to a donor-advised fund. That yields two benefits: It washes out the taxes due on the appreciation and potentially earns a tax deduction on the value of the contributed shares. Even though many fewer households are itemizing their deductions than in the past, the CARES Act passed in early 2020 made way for a $300 deduction for contributions of cash made to charity.

Alternatively, the qualified charitable deduction, or QCD, is also available in 2020, allowing investors who are age 70 1/2 or above to donate up to $100,000 from their IRAs to the charity(ies) of their choice. Of course, because RMDs are not required for 2020, some investors might prefer to not touch their IRAs at all in 2020, especially if their balances are down. But the amount that the retiree steers to charity via a QCD is not taxable, and it also reduces the size of the IRA balance overall. Moreover, the QCD can be tied in with rebalancing, with QCDs sourced from the very securities that the retiree wanted to scale back on anyway.

 

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