When it comes to saving for retirement, there are many big questions to answer, including how much money you'll need to set aside for your golden years, where you want to spend those years, and what you want to spend them doing.
These questions are so big that it can be easy to lose sight of some of the seemingly more minor questions that, left unanswered, could significantly impact your retirement goals, such as — is it time to rebalance my 401(k)?
Many savers don't realize that regularly rebalancing your 401(k) can help you stay within your ideal risk level and help protect against financial losses.¹ As with any financial decision, consulting with an advisor or tax professional can help determine what's best for you. But if you're looking for where to start, below we'll break down the basics of rebalancing and how it plays a role in your retirement savings.
Keep reading to learn more about:
What does it mean to rebalance my portfolio?
How does a Gusto 401(k) keep your retirement savings on track?
What should (and shouldn't) trigger a change in your desired portfolio?
Rebalancing is the act of selling shares of an investment in your portfolio that has done particularly well, and using those funds to buy shares of another investment that has not. Rebalancing makes it possible to maintain your desired risk-reward ratio in support of your desired timeframe for reaching your retirement goals.
Why do portfolios need to be rebalanced?
Portfolios will naturally get out of your desired balance due to the fluctuation of underlying investments in the market, which can reflect in your portfolio. If you think about your portfolio as a pie chart, rebalancing is recommended when the slices of pie (or chunks, in our case) have drifted too much from the desired slice sizes.
Let's look at an example of a Gusto 401(k) participant who has a moderate risk tolerance and has chosen a portfolio with 65% stocks and 35% bonds. Over time, the allocation would be very different from the original target without any rebalancing of their portfolio. Why? The economy.
If the market is doing well, stocks will rise. Generally, this is because consumers tend to spend when the economy is stronger, leading companies to generate revenue. When the market drops, stocks fall. Even so, stocks will generally perform better than bonds in the long term. Therefore, after a few years without rebalancing, you may see that the portfolio allocation that was initially set to 65% stocks and 35% bonds has drifted to 75% stocks and 25% bonds, no longer in line with the participant's moderate-risk investment strategy.
Why is rebalancing your portfolio important?
Rebalancing your portfolio helps to maintain an investor's desired portfolio allocation. If your portfolio is leaning more in one direction than you intended, the performance may falter. To speak by example, if your portfolio was designed to be more aggressive (or open-to-risk) but has started to become more conservative (or risk-averse) due to market activity, you could potentially miss out on growth in those more volatile holdings. Conversely, if your portfolio was intended to be more conservative and drifted to become more aggressive, you could have more losses than you can accommodate. While both of these examples focus on the drawbacks, there's always the potential for things to work in your favor.
Like with many things in life, it's about your expectations. Your portfolio cannot perform to meet expectations — whether that be more aggressive growth or more moderate growth — if it's not designed to do so. Ultimately, the purpose of rebalancing is to maintain the desired risk-reward ratio in your earmarked portfolio for your goal, so your portfolio can have its best chance at meeting your expectations.
At a high level, how does a Gusto 401(k) keep your retirement savings on track?
While rebalancing can be done manually, Gusto Investment Services, LLC (“Gusto Investment Services”) through Gusto Retirement Services, LLC (“Gusto Retirement”) as your Gusto 401(k) plan recordkeeper automatic rebalances participant portfolios as part of our robo advisor services.² This is more or less what it sounds like — using systems to track your current holdings relative to your desired portfolio and rebalance automatically when it drifts too far from that intended mix.
We monitor your investment portfolio to track its performance relative to your desired allocations. When you have too much of a particular investment in your portfolio relative to your desired allocation, automatic rebalancing will sell off the excess shares of that investment and use those funds to purchase more shares of the investments that you had less of compared to your desired portfolio.
Ok, so how does that play out to keep my desired portfolio allocation on target?
If you're an active participant in your 401(k) plan, you will typically make regular deferrals into your 401(k) account. Gusto Investment Services automatically invests these funds in a way that keeps your asset allocation on target with your portfolio.
If your portfolio "drifts" more than 5% from its target allocation, Gusto Investment Services, through Gusto Retirement, will automatically rebalance your portfolio. "Portfolio drift" is calculated as the sum of each investment's absolute deviation from its targeted allocation, divided by two." Building on the example from earlier, since 10% is more than 5%, Gusto Investment Services through Gusto Retirement will automatically sell 10% of the stock holdings and buy 10% more in the bond holdings to rebalance the portfolio.
Finally, Gusto Retirement does a daily valuation of target allocations. Any residual holdings that have not triggered a rebalance because the portfolio did not reach a 5% drift will be sold per standing direction from Gusto Investment Services, and those funds will buy shares in the target allocation.
Since Gusto Investment Services manages only qualified accounts, and funds remain inside the account when rebalancing, no taxable event is caused by these sales and purchases.³
⚠️ Please note
With non-qualified or other taxable investment accounts, rebalancing your entire portfolio may not be the most tax efficient way of investing. Generally, when you sell investments, you will pay a capital gains tax on any gains you realize. Because of this, people might instead use ongoing contributions to balance their account to their targeted asset allocation.
In a retirement account such as a 401(k), you don't pay taxes when you sell investments. Instead, taxes are only paid when you withdraw funds (or before you even contribute, if you contribute to a Roth account).⁴ Therefore, for your 401(k) or other qualified plan funds, there is not the same incentive to hold on to your old investments if you have determined a new allocation is right for you.
Should I ever change my portfolio allocation?
Now that we've covered the ins and outs of rebalancing, let's revisit what might influence the portfolio that Gusto Investment Services is rebalancing for you.
There are two categories of variables to consider when investing: market variables and investor variables.
Market variables are inevitable changes to the market or economy, such as a recession or a considerable market boom. These are outside of your control and should already be factored into your target portfolio allocation when you choose it based on the historical performance of markets.
While the market may experience a few bad years, they are often followed by good years. Since retirement savings is typically a long-term investment goal, avoid letting the market's short-term volatility dictate your investment decisions.
By contrast, investor variables reflect your own personal situation as an investor. These could change based on your time horizon or a personal life event, such as marriage or the birth of children, that could prompt you to take fewer (or sometimes more) risks.
Your portfolio allocation should not change over time unless one of your investor variables changes. For many, time to retirement is the variable that will lead them to reevaluate the balance of their portfolio.
This content is for informational purposes only and is not intended to be taken as tax advice. Please consult a qualified tax and financial advisor to determine the appropriate investment strategy, investment, or managed portfolio for you. Investing involves risk and investments may lose value, including loss of principal.
FAQs
What is portfolio rebalancing?
Rebalancing is the process of selling shares of investments that have grown beyond your target allocation and buying shares of underweighted investments to maintain your desired risk level.
Why is rebalancing important?
Rebalancing helps maintain your intended risk-return ratio. Without it, market movements can shift your portfolio away from your goals, potentially exposing you to more or less risk than intended.
How does Gusto Investment Services handle rebalancing?
Gusto Investment Services, through Gusto Retirement, automatically rebalances your portfolio when it drifts more than 5% from your target allocation. This happens without creating a taxable event since funds remain in your qualified account.
When should I change my portfolio allocation?
You may want to review your allocation based on investor variables like your time horizon, life events (such as getting married or having children), or changes in risk tolerance, rather than short-term market fluctuations.
Disclosure
¹ This information is provided for illustrative purposes only, and is not intended to be taken as investment or tax advice. Consult a qualified tax and financial advisor to determine the appropriate investment strategy, investment, or managed portfolio for you. Investing involves risk and investments may lose value, including loss of principal.
² As a robo-advisor, once a 401(k) plan participant completes the suitability assessment, which is a simple questionnaire, Gusto Investment Services, LLC (“Gusto Investment Services”) recommends one of its six professionally managed portfolios composed of mutual funds via our proprietary software. Gusto Investment Services does not provide individual investment advice.
³ This content is for informational purposes only and is not intended to be taken as tax advice. Please contact a tax professional for further information.
⁴ Roth distributions will generally be tax-free if the following conditions are met: Roth contributions are always distributed tax-free. The earnings on Roth contributions will be tax-free if the following conditions are met: (a) you're either over age 59 ½, disabled, or have died AND (b) it has been 5 years since your first Roth contribution under the current plan. Please consult a qualified financial advisor or tax professional to determine what is applicable to your financial situation.
