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Retirement Planning: Having It Both Ways

By: Frank Armstrong

By: Frank Armstrong, CFP, AIF

It could be so simple. If average returns were real returns, retirees could assume they would make, say, 10% each year, spend 6%, and count on 4% growth. Alas, returns are highly variable, and the downside—having to sell equity assets in a down market—can be pretty scary. So, as a rule of thumb, investors should keep enough liquid assets to meet all their anticipated needs for at least five and preferably seven years.

As an example, an investor who anticipates needing about 5% of his capital each year should place between 25% and 35% of his investment assets in short-term, high-quality bonds. Retirees with greater or lower cash-flow needs can adjust the minimum bond percentage necessary to meet short-term needs. The rest can, with reasonable safety, be invested for long term growth in a global diversified equity portfolio.

Of course, some retirees will opt for an even more conservative portfolio. That’s all right, up to a point. Sleeping well is a legitimate retirement investment objective. Risk reduction and peace of mind can be well worth the cost.

But the cost of moving from, say, 30% bonds to 40% bonds is a reduction of expected return of about 1% per year. I’m constantly surprised at how many retired investors still are hung up on generating income from their investments. As previously discussed, the old retirement income prescription of bonds, convertible bonds, REITS, utilities, and preferred stocks will indeed generate high levels of income—but at a cost to total return, and with higher risk than is necessary.

The retiree’s best solution is the same as any other investor’s: Invest to meet total-return objectives at the lowest possible risk level. As we have seen, a combination of stocks and bonds dampens volatility, and provides the highest possible probability of success at moderate withdrawal rates. But if bond interest and equity dividends alone are unlikely to meet reasonable income needs, how to generate a reliable cash flow?

To get started, put enough cash in money-market funds to meet your income requirements for the next year. (This cash should be considered part of your bond-fund allocation.) Have all dividends and interest from other investments paid directly to the money-market account, and set up an automatic monthly transfer from this account to your checking account to meet your everyday needs. That’s it for now. Go sailing or play tennis for a year.

At the end of the first year, evaluate your account performance and asset allocation. You’ll need to rebalance your portfolio, while raising cash for the upcoming year. The strategy is simple: Buy low, and sell high. If stocks have done well, sell enough winners to meet your cash needs and then re-balance back to your initial asset-allocation plan. If stocks have done poorly, then just sell enough bonds to meet next year’s needs.

That’s why you should keep five to seven years’ worth of cash set aside in short-term bonds. Those short-term bonds can be a life raft during a storm in the equity markets. Imagine being several years into a bad market and having to start selling stocks. How are you going to feel then? Wouldn’t you rather have a bit much in bonds rather than not enough? Stock-market downturns are temporary, and every previous one, without exception, has been followed by recovery and new highs—but you won’t fully enjoy a rebound if you had to sell out beforehand.

An annual re-balancing forces the sale of the previous year’s winners and the purchase of the past year’s losers. This may be tough to do, because we are naturally emotionally biased toward our current winners and disgusted with poor performers. The longer a specific market trend continues, the harder it is to remember that all equity asset classes (whether large- or small-cap, for example) have good return prospects. While some investments may be trailing, you presumably selected them in part for their low correlation with your other holdings. The temptation to keep winners and dump losers may be strongest just before the trend shifts.

An annual review is greatly simplified for index-fund investors, because they need not be concerned with style drift or management underperformance or changes. Further, investors can expect top-quartile performance relative to active managers, with a great deal more consistency. And index funds are great for taxable accounts, because of their limited turnover relative to managed funds. (If you have both tax-deferred and taxable accounts, you should give serious attention to minimizing both income and estate taxes when setting your withdrawal strategy. Issues such as how to manage mandatory withdrawals at age 70 1/2, whether to convert to a Roth IRA, and what order to draw down your various accounts will have a huge impact on the bottom line both for yourself and your heirs. These situations can be so convoluted that they are often best addressed on an individual basis by a competent tax attorney or CPA.)

If you keep your withdrawals at a “reasonable” level, your portfolio should grow and prosper (unless we have an economic disaster worse than any since the depression). Periodically check in to see if you need to adjust your withdrawals. If all has gone well, you may even be able to give yourself a raise.

Resist the temptation to tinker endlessly with the account. It’s not likely to do you any good. Of course, it is appropriate to alter your asset allocation if you have a major change in objectives or life situation. And very occasionally there is new academic research that reveals a more efficient asset-allocation strategy. But the key phrase is “academic research”, which does not include aMoney Magazine interview with this month’s hot small cap manager!

Set your strategy in place, relax, and enjoy your retirement. You deserve it.