Back

Retirement strategies

Lesson in Course: Portfolio management (beginner, 9min)

I want to manage a portion of my retirement money. What is an easy way to get started?

Eureka!

What it's about: We can easily build and manage our own retirement account using our risk tolerance and a few ETFs

Why it's important: While there are some autopilot alternatives, doing it ourselves saves us money on management fees.

Key takeaway: We need to occasionally rebalance our portfolio so that it matches our risk tolerance.

Target-date funds are great for investors who prefer to have professionals manage their retirement accounts. These mutual funds are among the most popular investment options found in 401(k)s and effectively allow everyone to autopilot their accounts. One trade-off is that these funds are expensive and dig into our savings over the years. As an alternative, we can elect to manage our own retirement accounts.

Custom strategy

If we prefer to avoid target-date funds or don't have access to them, we can implement our own strategy that attempts to reproduce the same outcomes. A simple strategy can be broken into 3 steps.

  1. Start with a portfolio
  2. Increase contributions over time
  3. Decrease risk over time

Starting to build a portfolio

The strategy we start with should reflect our risk tolerance for the existing goal.

 A basic portfolio is easy to build

For a 30-year-old, the risk tolerance for retirement at 65 is usually between moderate and moderately aggressive. Leading asset managers like Charles Schwab and Vanguard recommend starting with a portfolio of 10-15% bonds and 90-85% stocks. 

Charles Schwab portfolio allocations

To start, let's focus on domestic, US-based companies — as we become more confident investors over time, we can start adding developing markets and emerging market stocks. Using a 3:1 ratio of large-cap to small-cap, we can create our retirement portfolio.

Sample ETF retirement portfolio

Let's assume we plan to save $300 a month into our 401(k) or IRA.

  1. 10% or $30 into bond ETF ticker: AGG
  2. 66% or $198 into a S&P 500 ETF ticker: SPLG
  3. 24% or $72 into a Russell 2000 ETF ticker: IWM
 

Increasing contributions over time

As we earn more income, we should start putting away more for retirement. The max we can contribute changes every year, so check the IRS website. For 2021, the most we can put in to qualify for a tax deduction is $19,500. When we plan on putting aside more than $19,500 a year for retirement, other retirement options like a Roth IRA are better for the excess contributions. We'll probably start out contributing less than the $19,500 a year ($1,625 a month) limit; however, as we earn more, increasing our retirement savings will lower our tax bill.

Increasing contributions help grow our nest egg

The amount we decide to increase every year should correspond with our retirement milestones. If our employer offers a match, we should be increasing our yearly contributions as aggressively as we can to take full advantage of the free money from our employers — at least up to the max match amount. We can talk to a tax professional or use online calculators to help optimize our contributions and minimize taxes owed for the year.

Decreasing risk over time

As we get older and retirement gets closer, our risk tolerance decreases, and we need to adjust our strategy. Also known as a glide-down, we can increase more protective assets by buying bonds while decreasing risky assets by selling small-cap stocks. Below is an example of what a glide-down might look like from Vanguard advisors.

Vanguard glide-down

Glide-downs are smooth transitions that bring a portfolio to a target allocation, the makeup of different assets. The target allocation at age 72 is about 30% stocks and 70% bonds. Once we reach age 40, we will start bi-annual portfolio reviews to lower the amount in stocks. 

Review steps:

  1. Update our monthly purchases
  2. Rebalance our portfolio
Sample glide down

Let's assume we are 42 and our retirement account is worth $150,000 and are still contributing $600 a month to our 401(k) or IRA.

Our current allocation:

  1. 10% or $60 into bond ETF ticker: AGG
  2. 66% or $396 into a S&P500 ETF ticker: SPLG
  3. 24% or $144 into a Russell 2000 ETF ticker: IWM

Our new allocation:

  1. 12% or $72 into bond ETF ticker: AGG
  2. 66% or $396 into a S&P500 ETF ticker: SPLG
  3. 22% or $132 into a Russell 2000 ETF ticker: IWM

Our allocation in 10 years:

  1. 40% or $240 into bond ETF ticker: AGG
  2. 45% or $270 into a S&P500 ETF ticker: SPLG
  3. 15% or $90 into a Russell 2000 ETF ticker: IWM
 

Rebalancing a portfolio requires us to look at our total holdings and make sure we meet our target allocation. 

Rebalancing shifts our money to meet our strategy

If our portfolio has drifted away from the target allocation, we would sell what we have an excess of and buy what we are missing. Over the years, our small-cap and large-cap stocks have likely appreciated faster than our bonds, causing the value of those investments to be larger than our target allocation.

Sample rebalancing

Let's assume we are 42 years old, our retirement account is worth $150,000, and we are still contributing $600 a month to our 401(k).

Rebalancing target:

  1. 12% or $18,000 in bonds
  2. 66% or $99,000 in large caps
  3. 22% or $33,000 in small caps

It's likely we will have more in large and small caps than our target above. We will need to sell SPLG and IWM and buy AGG until we reach the target amounts.

 

Actionable ideas

While this strategy takes more work to implement compared to a target-date fund, it allows you to be more hands-on with your investments. You can take a slightly more active approach in deciding when to take more risk, or when to dial it back. It's meant to be an alternative and is not mutually exclusive to target-date funds. Moreover, this strategy can also be applied to other goals with long time horizons such as property purchases or saving for a child's college education. 

Supplementary materials

IRS contribution limits

We can find the contribution limits each year by going to the IRS website:

https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-contributions 

https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-contributions
For more information about the Charles Schwab portfolio allocations
https://www.schwab.com/resource/investment-questionnaire
Pre-Tax Savings Calculator

How much can pre-tax contributions reduce your taxes?

https://ffcalcs.com/pretax_savings 

https://ffcalcs.com/pretax_savings