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7 Tips for Annually Rebalancing Your Retirement Accounts

Craig Stephens

Market prices are certain to fluctuate every year and cause your portfolio to fall out of sync with your target asset allocations. Rebalancing your retirement accounts is a vital practice for keeping your retirement plan on track. This should be at least an annual exercise, but is often neglected by do-it-yourself retirement investors. While starting anew with goals and resolutions, January is a good time to make sure your investments are properly aligned with your long-term objectives. Here are seven tips for annually rebalancing your retirement accounts.

[See: How to Max Out Your 401(k) in 2019.]

Reestablish target allocations. At the start of the year, initiate a comprehensive overview of your finances. Evaluate whether your target asset allocation percentages are still in line with your needs considering your age, life expectancy, risk tolerance and retirement income requirements. A basic rule of thumb to determine the percentage of your invested assets to be allocated to stocks is to take the number 110 and subtract your age. For example, if you're age 50, aim to have 60 percent of your invested assets in stocks and 40 percent in bonds and alternative assets such as real estate or commodities. If it's your first time setting a target asset allocation, it may be wise to consult with a fiduciary financial advisor for guidance.

Consolidate accounts to simplify rebalancing. Retirement-age investors often have money spread over several accounts. Make sure to rebalance your allocations based on your total invested assets. This can be accomplished in one of two ways: You can rebalance each account at your target allocation percentages or rebalance based on the aggregate value of all your accounts combined. The more accounts and varying balances you have, the more tedious this process can be.

To make the annual rebalancing process easier, consider consolidating accounts. Combining accounts has several benefits including all-in-one account management, reduced tax forms and simplification. Retirement and taxable accounts must stay separate, but maintaining multiple account types under one brokerage can help to reduce financial clutter.

Reevaluate fund selections. While you're looking at asset allocations, it's a good time to evaluate your fund selections. Check for any fund management shakeups or significant increases in expense ratios. Consider switching out of high-cost underperforming funds for lower-cost options such as index funds and ETFs. Avoid making knee-jerk changes based on one-year fund performance metrics. Instead, use the five to ten-year returns and evaluate them against each fund's benchmark. Make sure to diversify your funds considering domestic and international exposure. Pay attention to the stock fund's top holdings and aim to diversify among large, mid and small-capitalization companies.

[See: 9 Ways to Avoid 401(k) Fees and Penalties.]

Ignore market returns. When you rebalance your retirement accounts, it should not be motivated by past market performance. Rebalancing is about aligning your current allocations with your investment objectives going forward. Choose a month when you plan to rebalance and stick with it. As you rebalance, your portfolio will naturally reduce holdings in overperforming assets and move them to underperforming assets. By annually reverting to the target allocations set forth at the onset of the rebalancing process, your portfolio is reset without emotional bias.

Rebalancing 401(k)s versus IRAs. Employer-sponsored retirement savings plans such as 401(k)s and 403(b)s have similar tax qualities to traditional individual retirement accounts. However, rebalancing each type of account is different because of the available investment options. Employer 401(k) and 403(b) plans have limited fund selections and little to no access to individual stocks or ETFs. IRAs, on the other hand, have broader access to thousands of investment options.

For 401(k)s, most administrators offer a rebalancing option that allows you to set your investment funds and allocation percentages with one transaction. Take advantage of that. For IRAs, start with your current allocation percentages and compare them to your target allocations. Put any excess cash toward the underfunded asset. Then, determine which funds need to be sold and bought to achieve your target allocation. Use fund exchanges to sell one fund and then buy another. Aim to complete the rebalancing with as few transactions as possible.

Adjust contributions. Once you've rebalanced your account, the next step is to adjust your regular contribution percentages. Your 401(k) or other employer-sponsored retirement plan may provide online access to make this change. Some plans might require contacting your human resources department. When selecting your future contributions, follow the same allocation percentages you used when rebalancing your account. Direct new contributions into the same stock and bond funds or select a new fund to broaden the diversity of your holdings. This will help you stay aligned to your target allocation throughout the year.

[Read: How Much Should You Contribute to a 401(k)?]

Tolerance rebalancing. An alternative method of rebalancing is called tolerance rebalancing, also known as threshold rebalancing. This method ignores the calendar and instead relies upon portfolio variance thresholds as the trigger mechanism for initiating a rebalance. The investor selects a tolerance percentage and rebalances when the tolerance is met. For example, if an investor has a 60/40 stock to bond target allocation with a 5 percent tolerance threshold, rebalancing should be initiated when the portfolio allocations reach 55/45 or 65/35. The rebalancing process brings the allocation percentages back to 60/40.

This method requires more diligent portfolio monitoring and may be more effort than is needed for most self-directed investors. Those working with a financial advisor should discuss the pros and cons of tolerance rebalancing versus calendar year rebalancing and choose the method best aligned with their long-term objectives.

Craig Stephens is a blogger at Retire Before Dad.



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