Once you have actually retired and started living on income from your assets, you’ll need to manage your withdrawals and investments to protect your wealth and maintain your lifestyle. There are actually three things that funds must be protected against in retirement. The first is that the portfolio might be exhausted through spending before the end of one’s life. The second is that the value of the portfolio may drop due to market fluctuations. The third is that inflation wastes away the value of the portfolio, forcing one to lower one’s standard of living.
Prevention of running out of money is done by making reasonable withdrawals for living expenses based on the value of the portfolio. (Note this requires you have a big enough portfolio to cover living expenses, which means you need to start planning and investing when you still have many years to build up you assets.) Typically a withdrawal rate of 4% of the portfolio value each year is small enough to almost ensure the money will last. Some strategies start lower and increase withdrawals to keep pace with inflation.
The larger your portfolio, and the lower your expenses, the more risk you can take with the money and therefore the greater return you can generate. For example, if you have $5 million in assets and need $80,000 per year in income, you could probably use $2 million to generate enough cash for expenses and then invest the other $3 million in stocks for a higher return. As the stock portfolio grew, you could divert some of the profits into your income generating account and increase your income. If you only had $2 million in your portfolio and needed $80,000 per year in income, investing a significant amount in equities would be too risky.
Protecting oneself against drops in portfolio value is done by holding enough wealth in cash (money market funds and CDs) to pay for near-term expenses, and diversification for money not needed immediately. Holding cash ensures that one will have the money needed to pay for expenses no matter what the market does over periods of a few years. After most market declines previous price levels are regained after a period of one to five years. For this reason having enough money in cash instruments to last five years is typically enough. Ten years almost guarantees the ability to weather a storm. Money can be invested in CDs of staggered terms to maximize returns, e.g., money not needed for three years would be in a 3-year CD, while money needed next year would be in a 1-year CD and so on.
Money not needed within the next 5-10 years must be invested to prevent loss to inflation. These funds should therefore be invested in common stocks, bonds, and real estate (either directly or through REITs). To reduce the risk of loss and reduce volatility, investments should be well diversified – spread over several different mutual funds, types of assets, and areas of the market. The goal here is not to beat the market but instead to simply make returns greater than inflation while reducing the chances of loss of capital as much as possible. Ideally during major stock market declines the bond and real estate holdings will limit losses to 10-20%.
Given this basic strategy, I’ll talk about some different specific strategies for structuring a portfolio to provide the needed income, inflation protection, and principle protection in posts that follow. At times it is relatively easy – you just invest in bonds and dividend paying stocks to provide the needed income. Other times, like the current period of low interest rates, are more difficult. We’ll start with the traditional method in the next post.
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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.
