What is the Best Portfolio Allocation Immediately Prior to Retirement?

What should you allocate to stocks and bonds just prior to retirement, say, in the last 2 to 3 years of work?  This is a question that all of us without lucrative defined benefit pensions will have to confront at some point.

There are basically two schools of thought:

1. Use a standard allocation based on your risk tolerance, age, and other factors, i.e. don't do anything special.
2. Reduce the risk in your allocation by holding more cash and/or short term bonds.

Point 1. is the current wisdom "stay the course" as I discussed in earlier postings.

Point 2. is interesting and it is based on the notion that the most critical time for your retirement in terms of finances are the first 1-3 years before and after retirement.  If the stock or bond market goes down significantly, your early withdrawals will deplete your nest egg too quickly too early and you will outlive your money.  This Marketwatch article and the papers it references give a good explanation, but the figure below taken from the Thornburg webpage  illustrates it best.

Figure 1: Two scenarios for retirement at two different points in time from Thornburg

In the positive blue scenario, our lucky retiree has a 60/40 stock/bond portfolio and retires in 1989, takes out 5% in the first year and increase withdrawals by inflation, and 21 years later, the $1M nest egg has grown to $2.6M.  In the unhappy green scenario, our unlucky retiree also has a $1M nest egg split 60/40 but retires in 2008 and makes the same 5% withdrawal, but the nest egg falls to $0.8M - only 30% of the riches of our lucky retiree.  This is a rather drastic scenario as it has a high withdrawal rate (5%), and the unlucky retiree retires at the start of the "Great Recession".  But it does illustrate the concept.  You can think of these two scenarios as the "best case" and "worst case" of the 5000 scenarios run by the Vanguard Monte Carlo tool referenced in my blog previously.

There is no consensus in the industry today whether to change your allocation just prior to and after retirement, but it is something to think about and maybe discuss with your financial advisor.  My solution was to accumulate about 1.5 years of expenses in a super-low-risk bank savings account just prior to my career shift/retirement.