Investing Specialists

An Investing Road Map for Pre-Retirees

Christine Benz

Each year in advance of our annual Portfolio Makeover series, I receive scores of emails from individuals who would like to be featured. I hear from folks with eight-figure (yes, eight) portfolios and people getting by on a shoestring, individuals with full pensions as well as job-hoppers whose investments are a web of 401(k)s and IRAs in multiple silos.

If there's a unifying theme among many of the submissions, it's that so many of them come from people who are getting close to retirement. While I haven't calculated a mean age for submissions I receive, the vast majority of investors who submit their portfolios are between the ages of 55 and 65. Most of them are still working, but beginning to test the waters on retirement readiness. They'd like another set of eyes on the viability of their plans, as well as the positioning of their portfolios.

It's no wonder that so many investors seek out extra guidance at this life stage, because decumulation is fundamentally more complicated than building up a portfolio in advance of retirement. Investors hurtling toward retirement quite reasonably wonder about the viability of their plans--whether they'll have enough and how much they can take out of their portfolios each year--as well as the structure of their portfolios. In an era in which yields have dropped steadily downward for the better part of three decades, it's not intuitively apparent how to structure a portfolio to deliver the necessary cash flows for retirement.

Because retirement readiness is such a crucial topic, we devoted this year's individual investor conference to it, harnessing the wisdom of Morningstar experts as well as external experts. As you plot out your strategy at this life stage, here are the key tasks to tackle.

Nourish Your Human Capital
In previous articles geared toward early- and middle-career accumulators, I emphasized the importance of continuing to invest in your human capital--your lifetime earnings power. True, large-scale outlays of time and money to build up your resume don't usually make a lot of sense later in life, but investing in continuing education and staying current on developments in your field do. Keeping abreast of the latest technology developments--both inside and outside of your workplace--is also crucial. After all, the best thing you can do to improve the financial viability of your retirement plan is to put in as many years in the workplace as you can. While older workers were laid off at a lower rate than the general population during the recession, it took them longer, on average, to replace the jobs they had lost than was the case for their younger counterparts.

If you're not interested in sticking it out in your main career any longer than you absolutely need to, you might still consider an "encore career"--a later-in-life job that's more gratifying and less taxing (but potentially less remunerative) than your main career. Being able to earn income from even a part-time job can reduce in-retirement portfolio withdrawals, thereby helping to ensure that your portfolio lasts longer than it otherwise would.

Start Mulling Your Social Security Strategy
Staying in the workforce up to or beyond traditional retirement age has another salutary benefit: It can help you delay filing for Social Security, thereby enlarging your benefit when you eventually do file. The Social Security Administration's Retirement Estimator allows you to model out your Social Security benefits based on various Social Security start dates. Married couples should take special care to strategize about Social Security together, with an eye toward enlarging their total lifetime benefits from the program. (If one spouse is younger and will gain a larger benefit from a spousal benefit than his or her own benefit, delaying receipt of benefits will be particularly advantageous for the older, higher-earning spouse.)

Maintain Your Safety Net
The usual insurance recommendations apply for the years leading up to retirement: property and casualty, personal liability, and health and disability, of course. If your children are grown and off your payroll, it's also wise to revisit your need for life insurance at this stage; while life insurance can make sense in some instances, you'll have less of a need for it once your dependents are grown.

Long-term care insurance may be prohibitively expensive by the time you reach your early 60s, or you may have encountered a health condition that disqualifies you from buying it. But it's still worth pricing out a policy, especially if you have built up a sizable but not enormous nest egg. This article shares some statistics on long-term care usage and insurance.

Maintaining an adequate emergency fund remains important at this life stage. Because higher-income and/or more specialized jobs are often more difficult to replace than is the case for people who are earlier in their careers, consider holding at least a year's worth of living expenses in liquid assets, rather than settling for the standard advice of three to six months worth. There's an opportunity cost to holding too much cash, of course, but having an adequate cushion will keep you from having to raid your retirement assets prematurely.

Assess the Adequacy of Your Portfolio
With five to 10 years to go until retirement, it's time to take a close look at the viability of your portfolio. It's not too early to apply the 4% guideline to your nest egg: Is 4% of your total retirement portfolio--less whatever your tax rate is--an amount that you could live on, when combined with other income sources like Social Security or a pension? For a more detailed check on your portfolio's viability, use a retirement calculator like T. Rowe Price's Retirement Income Calculator and Vanguard's Retirement Nest Egg Calculator.

Even if you've been a dedicated do-it-yourselfer throughout your investment career, this is also an ideal life stage to check in with a financial advisor to assess the viability of your plan, as well as the structure of your portfolio.

The good news is that if you have five to 10 years left until retirement, you still have some levers left to pull if it looks like you could have a shortfall; working past 70 won't be your only option.

Embark on a Pre-Retirement Saving Sprint
Many parents spend their 40s and 50s multitasking on the saving front, stashing money away for both college and retirement (and often beating themselves up for not doing a great job on either). With college expenses receding in the rearview mirror, your final working years before retirement are an ideal time to give your all to retirement savings. Financial planning guru Michael Kitces notes that "the empty nest transition" provides an opportunity for people in their 50s and 60s to avert a looming retirement shortfall. He estimates that 15 years of saving 30% of income--no small feat, of course--before retirement can help bring a too-small retirement portfolio back from the brink.

You should still favor tax-sheltered vehicles like IRAs and 401(k)s at this life stage, taking advantage of the additional $1,000 (IRA) and $6,000 (401(k), 403(b), 457) in catch-up contributions allowable for people who are post-age 50. Health-savings accounts, which boast tax-free contributions, compounding, and withdrawals, can serve as additional funding vehicles for investors who have already maxed out their dedicated retirement accounts; catch-up contributions to these accounts are available to people over age 55.

Building assets in nonretirement accounts will also provide valuable flexibility once you begin drawing down from your accounts in retirements. By employing tax-efficient investments like equity index funds and exchange-traded funds as well as index funds, you can reduce the ongoing tax drag on your taxable portfolio. Moreover, you'll be able to enjoy today's relatively low (or even zero) capital gains rates when you withdraw your assets, giving you valuable flexibility to control your tax bill in retirement.

Build Your Stake in Safe(r) Securities
As retirement approaches, it's crucial to begin reducing risk in your investment portfolio. Holding a share of your portfolio in lower-risk assets like short- and intermediate-term high-quality bond funds can help you reduce the damage from what retirement researchers call sequence or return risk--the possibility of encountering a lousy market early in your retirement years. That risk is one that people approaching retirement should be keenly attuned to today, owing to not-cheap equity valuations. By holding enough assets in safer securities as retirement approaches, you can help safeguard against the need to withdraw from stocks when they're depressed, thereby improving your portfolio's long-run viability.

Yet even as pre-retirees need to build an adequate cushion in safer securities, it's crucial to not go overboard. People in their 50s and 60s still need plenty of stocks, as they likely have 30 or even 40 years ahead of them. Thus, they have an ample amount of time to absorb the higher volatility that comes along with stocks in exchange for the potential for higher returns. That explains why the Aggressive version of Morningstar's Lifetime Allocation Indexes for 2025 retirees stakes more than three fourths of its assets in stocks, whereas the Moderate 2025 index includes roughly 60% in stocks.

Think about Withdrawal Sequencing
If you still have five to 10 years before retirement, it may seem premature to start thinking about which accounts you'll draw upon when you begin spending from your portfolio. But doing so before retirement approaches can influence how to position each of those pools of money. The standard sequence for in-retirement withdrawals is taxable accounts first, followed by traditional tax-deferred, with Roth last in the queue. That argues for putting more liquid assets in your taxable accounts (which you have probably done anyway, assuming you're holding your emergency fund there). Meanwhile, the most aggressive, highest-returning assets (usually stocks) belong in your Roth accounts. Because they will likely fall into the intermediate part of your distribution queue--and also likely compose the biggest share of your portfolio--your tax-deferred accounts can hold a blend of safer, income-producing securities like bonds as well as higher-returning, higher-risk assets like stocks. This article takes a closer look at the topic of withdrawal sequencing.