For most clients, today's version of retirement will likely include part-time work or flexible working arrangements, in addition to income from Social Security and retirement plans (for those who have them).
In general, most clients are financially unprepared to stop working completely. According to the Federal Reserve's Survey of Consumer Finances, only 51.7% of families headed by a person 65 or older has a retirement account. The median value of the retirement account among those surveyed was $80,700.
Not only do the economics of retiring dictate that most of us plan to work even after we qualify for Social Security, but so does the biology and sociology of retiring — people are living longer and healthier lives. Many people continue to enjoy the positive benefits of working even when they've reached the Social Security system's full retirement age.
It may be that employment for some of the “Medicare eligible” becomes an opportunity to explore hobbies that could end up generating income. Earning money from an area of interest, with no concern for health care benefits, can provide a greater sense of well-being and fulfillment. Employees who don't demand health care or retirement benefits are attractive to potential employers as well.
ADDING HUMAN CAPITAL TO THE ASSET ALLOCATION PIE
With these changes as a backdrop, it becomes clear that retirement conversations need to move beyond topics like Social Security's antiquated concept of full retirement age. When we consider the impact of human capital on the asset allocation pie, it is obvious that advisers need to incorporate any earned income stream into retirement planning. Employment-generated income combined with income from Social Security can count towards the fixed-income allocation of a retirement portfolio. By continuing to work in retirement, investors can take on more equity exposure within their financial portfolio.
A common rule of thumb has been that as individuals get older, more of their investments should be allocated to bonds. This rule is derived from adding human capital and financial capital together for a person's total portfolio. A young person's future income stream can be viewed as a type of bond with various options: the bond portion comes from periodic and predictable income while the options come from the ability to switch jobs, change consumption patterns or extend one's work life. Because of this bond-plus-options character of human capital, the person's financial portfolio can be skewed toward equities to keep a balanced total portfolio.
Today's retirees may continue to benefit from these options regarding employment. However, like options, human capital also has something called time decay, meaning the option's value declines rapidly as its expiration date approaches. It may become harder to switch jobs once a person accumulates a certain amount of experience or seniority. The “golden handcuffs” can make it difficult to switch out of a high-salary-good-benefits job into something lower on the corporate ladder. Hitting retirement, however, can make it easier to rationalize and stomach a dramatic change.
THE CONTINUING VALUE OF HUMAN CAPITAL
Twenty-first century retirement, which includes income generation from some level of employment, requires a new asset allocation model.
We suggest an emphasis on actively managed investment strategies, particularly those that are benchmark-free. These also may be referred to as absolute return strategies. The investment manager's goal is to beat inflation by a significant margin over an entire investment cycle. This is also an argument for investing with a fixed-income manager who isn't constrained to hugging a benchmark, kind of a “fixed-income plus option” strategy to better mimic, at least in theory, human capital.
Greater equity holdings
Since people who choose to work in retirement can effectively use their employment income to offset some of what would typically be allocated to fixed-income securities, they can likely afford to hold more equities in their 21st century style retirement than the conventional retirement asset allocation would dictate. The extent to which they can allot more to equity exposure depends on the amount of income they generate from working and the predictability of that income. This requires a standard present-value calculation that every adviser should be familiar with. When you add the present value of Social Security income with the present value of work income, you can get a good estimate of the dollar amount of fixed-income allocation that can be displaced in a retirement plan.
Smaller cash allocation
In last century's version of retirement, a spending account — typically in the form of a money market account — is a needed source of funding for immediate and incipient expenses. For someone with other sources of income — for example, a job in which a periodic paycheck is the source of immediate and near-term funding — the cash slice of the asset allocation pie can get slimmer. The source of income is the analog to the retiree's spending account. For example, if you can rely on a semi-monthly paycheck, that dollar amount can offset or reduce the amount you need in a spending account. Social Security and work income can fill up the bucket you would typically dip into the financial asset well.
An investor with a job will also likely want some cash holdings to account for any possible job loss, but that should be seen as a type of insurance rather than part of an investment strategy. Thus, retirees who are also working may require a smaller cash allocation than the typical retirement asset allocation would suggest.
The new 21st century retirement, in which people live longer and stay at least partially attached to the labor force, can transform today's view of asset allocation in retirement. Instead of the old notion of an increasing allocation to fixed income to provide stability and income, employment income can serve as a substitute. Predictable income also can lower cash demands for retirees. Thus, the asset allocation of the new retiree should likely have a lower exposure to cash and fixed income than traditional models would suggest. Financial advisers looking to stay relevant in the 21st century must rethink asset allocation for 21st century retirees.
Brian Jacobsen is chief portfolio strategist at Wells Fargo Funds Management and an associate professor at Wisconsin Lutheran College where he is the director of the Financial Planning Program.
Wayne Badorf is head of intermediary sales at Wells Fargo Asset Management and president of Wells Fargo Funds Distributor.