If you’re planning to retire in your 40s or 50s, deciding how much to invest in bonds is a balancing act. You want enough growth to fund a retirement that could last 40 or 50 years, but you probably don’t want every dollar tied to the ups and downs of the sharemarket.
Bonds can make your portfolio less volatile and provide income, but they generally offer less long-term growth potential than shares. Hold too many and you could make it harder to keep pace with inflation. Hold too few and you might find market swings difficult to stomach, particularly once you’re relying on your investments to pay the bills.
There’s no universally correct percentage. However, there are a few ways to work out what makes sense for your circumstances.
Start with how much you’ll need from your bonds
The amount you plan to withdraw each year can help you decide how much of your portfolio to keep in bonds rather than shares.
Say you retire with $1 million and expect to spend $40,000 a year. You could keep the entire portfolio invested in shares, but that leaves you relying on selling shares or receiving dividends to fund your living costs. Alternatively, you could hold some bonds to provide interest income and a source of funds outside the sharemarket.
For example, a portfolio with 80% in shares and 20% in bonds would give you $200,000 in bonds. That’s equivalent to five years of your planned $40,000 annual spending, before allowing for interest, taxes, fees and changes in the value of your investments. It doesn’t mean the bonds will cover five years of expenses in practice, but it gives you a useful way to think about the size of your defensive allocation.
Now imagine you need to withdraw $60,000 a year instead. The same $200,000 bond allocation represents just over three years of spending. You might decide you want a larger bond holding, or you might prefer to keep more money in shares because your portfolio needs greater long-term growth to support those withdrawals.
Neither choice is automatically right. Bonds can provide income and help diversify your portfolio, but their returns may not be enough to fund your spending on their own. And if you hold too much in bonds, you may sacrifice growth that you’ll need later in retirement.
The useful question is how much of your spending you want your bond allocation to help cover, and how much you need to leave invested for growth. Your withdrawal rate, other income and tolerance for risk can help you find that balance.
What different bond allocations look like
Traditional portfolio rules can help you think about the trade-off between growth and stability. They aren’t prescriptions, particularly for someone retiring decades earlier than the traditional retirement age.
Here are three allocations to compare.
An 80/20 portfolio: prioritising growth
With 80% in shares and 20% in bonds, most of your money remains invested for long-term growth.
This might suit an early retiree with a relatively low withdrawal rate, a high tolerance for volatility and a long investment horizon. It also means accepting that your portfolio could fall substantially when sharemarkets struggle.
The 20% bond allocation provides some diversification, but it won’t prevent large losses or necessarily rise when shares fall.
A 60/40 portfolio: balancing growth and stability
A portfolio with 60% in shares and 40% in bonds gives defensive assets a more substantial role.
It may appeal to someone who wants to reduce portfolio volatility or who is uncomfortable having most of their investments exposed to shares. The trade-off is that a smaller proportion of the portfolio is positioned for equity-market growth.
For someone retiring at 40, that matters. Their investments may need to support them for another half-century, so a portfolio that feels comfortable today still needs to generate enough growth to fund future spending.
A more conservative portfolio: prioritising stability
A portfolio with 40% in shares and 60% in bonds places even greater emphasis on defensive assets.
This may appeal to someone with a lower tolerance for market fluctuations or particular spending needs that make stability a priority. But it isn’t automatically safer in every respect: inflation can erode purchasing power, and bonds can lose value too.
For an early retiree, the question is whether the expected growth from such a portfolio is sufficient to support their spending over a potentially very long retirement.
These examples illustrate the trade-off, rather than establishing a best allocation. The right mix also depends on which bonds you hold, the rest of your assets and your financial circumstances.
Should you use your age to set your allocation?
One traditional guideline is the “100 minus your age” rule. Under this approach, a 35-year-old would hold 65% in shares and 35% in bonds. The logic is straightforward: as you get older, you gradually reduce your exposure to growth assets. But early retirement complicates that idea.
Someone retiring at 35 might need their investments to last longer than someone who retires at 65. Automatically reducing their share allocation because they’re getting older could leave them with less growth potential than they need.
Age is still relevant, but it shouldn’t be the only factor. Your withdrawal rate, other sources of income and ability to withstand losses are just as important when deciding how much to hold in bonds.
You don’t have to keep the same allocation forever
Your ideal portfolio at the point you retire doesn’t necessarily need to look the same 10 or 20 years later.
One approach is a bond tent. This involves increasing your allocation to bonds in the years around retirement, then gradually reducing it as you move further into retirement. The aim is to provide additional stability during a period when you’re starting to rely on your investments, without committing to a permanently high bond allocation.
Another option is to separate your investments by when you’ll need the money. Cash can cover immediate expenses, bonds and other defensive assets can contribute to medium-term spending, and shares can remain invested for longer-term growth.
Neither approach is foolproof. A bond tent requires decisions about when to increase and reduce your allocation, while a bucket strategy can leave too much money sitting in lower-growth assets if you’re not careful. Still, both illustrate an important point: you can manage your portfolio around your spending needs rather than choosing a bond percentage once and never revisiting it.
Don’t forget your super
If you’re planning to retire early in Australia, you also need to consider where your investments are held.
You’ll generally need enough money outside super to cover your expenses until you meet the applicable conditions of release. For many people, this means funding the years before they can generally access super at 60.
This is sometimes called your bridge portfolio. It may need to cover a decade or more of spending, depending on when you retire and your circumstances.
You could choose to hold some cash and defensive investments in this accessible portfolio while keeping your super invested for longer-term growth. But don’t overlook the need for growth outside super, too: your bridge portfolio might need to last for decades.
Tax can also affect the decision. Bond interest is generally taxed as ordinary income at your marginal tax rate, while eligible investors in Australian shares may receive franking credits. The tax treatment of your investments is worth considering alongside your allocation, rather than using it to determine the allocation on its own.
How to choose your starting point
Before settling on a percentage, work through these questions:
- How much will you withdraw? Estimate your annual spending during retirement and calculate the proportion of your portfolio you’ll need to draw down.
- How long must your money last? Retiring at 40 creates a different challenge from retiring at 60. Your portfolio needs to balance current spending with future growth.
- How much volatility can you tolerate? Consider whether you’d be comfortable seeing your portfolio fall sharply without abandoning your plan.
- What other resources do you have? Cash savings, other income and the flexibility to reduce spending can all influence how much defensive exposure you need.
- When can you access your money? If you’re retiring before you can access super, account for the investments you’ll need to fund that gap.
Once you’ve chosen a target, review it periodically. Market movements can change the balance between shares and bonds, while changes to your spending or retirement plans can alter how much risk you’re able to take.
So, how much should you hold in bonds?
For an early retiree, the decision comes down to how much growth you need and how much investment volatility you’re prepared to accept along the way.
A portfolio weighted towards shares may be appropriate if you have a relatively low withdrawal rate and a long investment horizon. A larger bond allocation may suit someone who places greater value on stability or has less flexibility to manage fluctuations in their investments.
Neither approach is inherently right. A portfolio can be too conservative to support your long-term spending, just as it can expose you to more volatility than you’re comfortable handling.
Start with your spending needs and withdrawal rate, then work out how much of your portfolio needs to be invested for growth and how much you want in defensive assets. Revisit that balance as your circumstances change.
The aim is to build a portfolio that can support your lifestyle today without compromising your ability to fund the decades ahead.
Disclaimer: This article is general in nature and does not take into account your individual objectives, financial situation or needs. The portfolio allocations and examples are illustrative only and should not be taken as investment recommendations. This article does not constitute financial, tax or superannuation advice. Before making investment decisions or changing your portfolio, consider seeking advice from a qualified financial adviser or registered tax agent.
