With all of the media attention surrounding how much money 401(k)s are currently losing, retirement planning has become a real topic of interest. Many individuals that were about to retire are considering working a little longer to see if they can recoup some of their loses. Others with more years ahead of them are looking around for a new strategy that will make their retirement savings more resistant to market fluctuations.

One such approach that is currently gaining favor among many financial planners is lifecycle investing. It takes into account the natural course of events in the investor’s life and uses this information as the basis for making investment decisions. To help TH readers better understand how this strategy can be used to create a dynamic retirement portfolio, Robert A. Imparato Jr., CFP®, Retirement Planning Specialist, and Craig Hyldahl, CFP®, CDFA, Principals of R.I.C.H. Planning Group, and AXA Advisors, agreed to talk about it:

How would you define lifecycle investing in terms of creating a retirement portfolio?

“Life cycle investing is setting up a portfolio so that it’s in line with your age and target year for retirement. For example, life-cycle mutual funds make it easy for novice savers to buy a diversified array of stocks that are tailored to their age and retirement goals. That’s because these funds are set up to automatically pick and choose the equities in the fund, and to rebalance those holdings over time, buying and selling shares in order to maintain the advertised mix of risk and return (or caution and predictability) by age bracket.”

What is risk tolerance, and how does age impact it when saving for retirement?

“The standard definition of risk tolerance is the willingness of an investor to tolerate risk in making investments. A high-risk tolerance indicates a willingness to invest in more risky investments, and vice versa. In modern portfolio theory, higher risk is assumed to be rewarded by higher potential returns, so individual risk tolerance may limit the kind of return an investor can reasonably expect. Individual risk tolerance is based on many factors, such as comfort level, and other personal circumstances, such as years left until retirement (if any) and level of financial security. Financial advisers typically try to estimate their client’s risk tolerance before making an asset allocation strategy. The traditional approach is to increase the allocation to bonds as risk tolerance diminishes.

“In practice, risk tolerance is very difficult to quantify. A financial professional needs to sit down with the client and look at the whole picture. Before determining risk tolerance the client needs to determine what their goals and objectives are. There is no generic example to this. Each client is unique – are your parents still alive? Is life longevity a factor? What’s the time horizon? These are some of the things under the hood of risk tolerance.

“One of the biggest issues we come across when reviewing new clients is that their portfolios do not take into account risk tolerance. Individuals need to continually update risk tolerance.”

When is the optimal time to begin saving for retirement?

“There is no optimal time. The simple answer is the sooner the better. The earlier you start saving, chances are the better off you will be. Time, not genius, is the great wealth builder.

“Whether the quote is true or not is undetermined, but it’s rumored that Albert Einstein was quoted as saying ‘The most powerful force in the universe is compound interest.’”

If you are past the optimal age to start saving, can you catch up?

“Start as early as you can. The month of October has been the worst month, performance-wise since 1931. Prior to October, if you asked people if they were on track for the retirement goals and objectives, they would have said yes. Can you catch up? It all depends.

“If you’ve waited until your 50s to start thinking about saving for retirement, you’re not doomed to a miserable retirement. By taking advantage of some special provisions that only apply to older workers, you can add to your retirement savings when you need it most.

“Catch up on your retirement contributions. Using a combination of IRAs and your 401(k) plan at work can help you build savings in a hurry. With limits of $5,000 on IRAs and $15,500 on 401(k) contributions for 2008, you can save more than $1,700 every month with big tax advantages.

“Yet those over 50 can contribute even more, thanks to so-called ‘catch-up’ provisions. To give older workers more opportunity to save, the catch-up provisions allow those age 50 or older to contribute an extra $1,000 to an IRA, and $5,000 more to a 401(k) plan.

“You can also take steps to get by with less money. Many retirees downsize to a smaller home or relocate to less expensive areas to make their money go further. In addition, reducing expenses before you retire has a double benefit. Not only will you get used to living on less, but you’ll also be able to put more aside toward retirement savings. That’ll make those catch-up contributions easier to make. Whatever you do, don’t give up: it’s never too late to start planning for your retirement.”

What is asset allocation, and how does an investor use lifecycle investment philosophy to determine asset allocation in a retirement portfolio?

“Asset allocation is the act of dividing your investment dollars into different categories, such as cash, bonds, stocks, and real estate, to get the maximum return for the risk you take. Risk is generally a function of time; the younger you are, the more risk you should take.

“The dominant determinant in positive long-term returns is proper asset allocation. Once the client’s investment time horizon and their risk tolerance is known, then we can create a properly diversified portfolio.

One thing we’ve learned about this market is that it’s showing people who thought they had a tolerance for risk (in theory) are risk averse in reality.”

What are some of the most common mistakes investors make when allocating assets?

“One of the biggest problems we encounter is that they don’t have a game plan. They never ask, ‘What’s the goal of this money?’

“In order to reach your financial goals, you have to know first where you’re going. For example, if you’re investing for retirement, you need to determine when you want to retire, how much you will need to live on in retirement, how much time your investments have to grow, and how much you can afford to save each year. Once you’ve answered these questions, you or your financial professional can develop the investment strategy that will help take you where you want to go. For each element of your financial future, you will need to plan. Your financial plan incorporates many elements, including investments, savings, insurance, and estate planning.”

How do you use asset allocation to avoid outliving your assets?

“Even if you’re an aggressive investor, it’s never a good idea to put all your eggs in one basket. Those who most successfully weather the market’s ups and downs are those who have a variety of investments—some fixed income securities along with a diversified stock portfolio that includes small and large cap, growth and value sectors.

“Asset allocation — the process of deciding which percentage of stocks and bonds in your portfolio is important for two reasons. First, by properly diversifying among different types of asset classes you are more likely to protect your portfolio on the downside, that is, when the market is falling. Second, since no one can predict what next year’s winners will be, having exposure to multiple asset classes increases the likelihood for potential gains.

“Your own asset allocation will depend on your age, your investment goals, your tolerance for risk, your tax bracket, and other variables. Please be aware, however, that asset allocation does not guarantee a profit or protect against loss.”

Is there such a thing as an “all weather” portfolio?

“The last three months have shown us that when there is panic in the market there is no such thing as an ‘all weather’ portfolio. Hedge funds, gold, oil, bonds, money markets all experienced losses. At this point, based upon what’s happened recently, there is no such a thing as an all weather portfolio.”

What is rebalancing, and how often should you review your portfolio to determine if it is necessary?

“We insist on seeing our clients face to face to review their risk tolerance annually.

“Your current strategies and asset allocations will only serve you for so long. Life circumstances change: children and grandchildren are born and grow up; your earning power increases; you get closer to retirement; you inherit money, and so forth. As your life changes, you’ll need to re-evaluate your financial plan to make sure it still meets your changing situation and goals.

“As the market goes up and down, your portfolio’s allocation will change — a run-up in small cap value stocks, for example, will increase the percentage you own in that sector, putting your portfolio out of balance. When you rebalance, you sell some of your winning sectors and buy more of the sectors that have not yet performed as well — thus conforming to the classic investment advice of ‘buy low, sell high.’ Rebalancing can help prevent your portfolio from taking on more risk than you had originally intended — and help you avoid possible losses when a formerly hot sector starts declining.”

As you can see, retirement planning is a complex process that doesn’t end even after you retire. Once you stop working, and you’re dependent upon your savings, you have to be sure that you will have revenue streams to pay for living expenses, as well as assets that will continue to accrue so that you don’t run out of money. The best way to do that is to work with a financial planner who can tailor a retirement plan to your individual needs and goals.