5 Ways Rebalancing Can Benefit Your Retirement Plan

The virtues of rebalancing are greater when you're retired than when you are accumulating.

Christine Benz 23 June, 2020 | 1:39AM
Facebook Twitter LinkedIn

Road work signs

Editor's note: Read the latest on how the coronavirus is rattling the markets and what you can do to navigate it.

Numerous studies have delved into the topic of whether rebalancing a portfolio--periodically trimming appreciated securities and plowing money into those that haven't 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's 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 doesn't help on the returns front relative to a portfolio whose equity allocation drifts ever higher.

Yet, I'd argue that how much value you place on rebalancing depends completely on life stage. Most younger investors don't worry too much about controlling risk in their portfolios; generating returns is where it's at. For them, periodically reducing risk through rebalancing falls into the category of "nice to have," but it's 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 I don't think are discussed enough among investment experts. 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's increasingly important in the current era of ultralow yields. Rebalancing can also help with diversification, taxes, and charitable giving.

Here's 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. That's partly why I think rebalancing can be so helpful in retirement, in that 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. That's why I recommend 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's 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. As we've seen in stark relief so far in 2020, many higher-yielding investment types are also 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. Even very good dividend-focused equity funds like Vanguard High Dividend Yield ETF (VYM) have lost about 10 percentage points more than the broad market so far in 2020. Meanwhile, yield-rich bond funds have struggled relative to high-quality bonds for similar reasons, as investors have questioned the ability of lower-quality borrowers to make good on their obligations.

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's not to say you should exclude yield-rich securities from your retirement portfolio altogether, but my bias would be to embed 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.
That 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. That sort of 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.

The recent market action provides a great example of how powerful rebalancing can be from that standpoint. Of course, few people saw this 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.
I like the idea of retirees doing 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. 

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.



Facebook Twitter LinkedIn

About Author

Christine Benz

Christine Benz  Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz.

© Copyright 2024 Morningstar, Inc. All rights reserved.

Terms of Use        Privacy Policy       Disclosures        Accessibility