Recently, a client of mine called because he is getting closer to retirement and feels like he needs to get more conservative in his 401(k). If you have ever read a finance book or listened to any financial “guru”, the investment advice is always the same; Invest more aggressively while you are younger and more conservative as you approach retirement. My client had heard this time and time again, and because in the next two years he will be retiring, it may make sense to lower the risk of his strategy. We have also done enough planning that I know this client is planning on taking the lump sum pension when he retirees, and it just so happens this is a pretty significant amount. Needless to say the client was surprised when I suggested, not only should we not get more conservative in his account, in fact maybe now is the time to get more aggressive! It’s not as crazy as it sounds.
Lump sum pension investment
For the most part, if you are getting a lump sum, you have some certainty of how much you will receive. Yes, the number may fluctuate slightly based on interest rate changes, however, it is a number that we can count on no matter the market conditions. In my client’s example above, he will have roughly a $500,000 lump sum when he retires in two years, along with $500,000 of his own savings, for a total of about $1 million at retirement. Yet, when he was looking at his portfolio, he was really just focusing on his personal savings and ignoring the lump sum. In other words, he has essentially $500,000 in cash that he will receive in two years, no matter if the market goes up or down 50% in the next two years. This upcoming lump sum payment, or current $500,000 essentially invested in cash, is skewing his total portfolio to much more conservative than he realizes.
Given that the lump sum is essentially a cash like account with no risk, you may want to take on more risk in the portfolio you do control. Let me give you an example. You have a $500,000 401(k) and expecting a $500,000 lump sum like the example above. You invest the 401(k) in a common 60% stocks and 40% fixed income portfolio. So, $300,000 of your total assets are in equities. This may be appropriate for your 401(k) but now let’s look at your overall risk, given a large lump sum which is essentially invested like cash. Now, given total assets of $1 million and only $300,0000 (30%) invested in equities, this person may be much more conservative than he thought.
Investing more aggressively in the 401(k)
Now, let’s assume that you actually want a 60/40 allocation (60% equities and 40% fixed income) including the 401(k) and lump sum. Well in the example above, the most equity risk he could take is 50%. He could allocate all of his 401(k) to equities, $500,000, and still only have a true 50/50 mix when considering he has a lump sum coming in the next couple years. This is why he can afford to get more aggressive in his 401(k).
It is important that you consider all of your assets when putting together an asset allocation. Yes, we are talking about treating the lump sum here as a cash asset, but it doesn’t have to stop just at the lump sum. You may have a significant amount in a savings account or have a fixed annuity. These should all be taking into account when making investment decisions in your 401(k). If you have these types of assets outside of your 401(k) you may have a more conservative allocation than you think. Therefore, it may be worthwhile to take on a little more risk in your 401(k).