Retired: Now What?
The need for retirement planning doesn’t end with the start of retirement. A new retiree’s focus shifts from building wealth to managing and preserving it. One major challenge is to make the investment portfolio supply cash flow for the duration of life—and through different economic and market conditions. Three main factors drive portfolio endurance: asset mix, spending level, and investment time frame. Certain aspects of these factors are within an investor’s control while others are not. Let’s briefly consider them.
Asset mix describes the ratio of stocks to bonds in a portfolio. This determines risk exposure and expected performance, and is one of the most important decisions investors of all ages can make. Historically, stocks have outperformed bonds and outpaced inflation over time. Consequently, the larger the equity allocation, the greater a portfolio’s expected return—and risk.
Keep in mind that risk and return go together. A higher allocation to equities increases the risk of experiencing periods of poor returns during retirement. But if you can handle the risk, having more equity exposure in a portfolio enhances its return potential. Growth can bring higher cash flow, inflation protection, and portfolio endurance over time. This is why most advisors believe that most investors should have some equity component in their portfolios, with actual weighting depending on one’s time frame, risk tolerance, and spending flexibility.
Portfolio withdrawals are typically described in terms of a specified dollar amount or a percent of annual portfolio value. Neither method is perfect, however—and for different reasons. Withdrawing a fixed amount each year and adjusting it for inflation can provide a stable income stream and preserve your living standard over time. But the portfolio may survive only if future withdrawals represent a small proportion of the portfolio’s value. Withdrawing a fixed percentage of assets based on annual asset value makes it unlikely that you will deplete retirement assets because a sudden drop in market value would be accompanied by a proportional decline in spending. But this method can produce wide swings in your living standard when investment returns are volatile.
Retirees who need consistent cash flow may want to combine these two methods. One way is to withdraw cash flow according to a rule that combines past spending with a payout rate applied to current portfolio value. You can weight these factors to favor your preference for either more stable cash flow or a greater chance of portfolio survival. In effect, you are customizing your withdrawals to smooth out spending while responding to actual investment performance.
Investment Time Frame
Investment time horizon may be the hardest to estimate, especially if it is the same as your lifespan. In this case, you can only guess how long your portfolio must support spending. If you plan to hand down assets to beneficiaries, your investment time frame may extend beyond your lifetime. This may influence your risk and spending decisions as well. Time frame forces a tradeoff between the short and long term. Retirees with a longer investment time horizon might choose a higher exposure to equities. But they may have to offset this risk by being more flexible about spending over time. Elderly retirees and others with a short time horizon may choose a less risky allocation or a higher payout rate, although they can experience rising spending levels, too. In any case, retirees should think carefully about equity exposure and avoid taking more risk than they can afford.
Planning involves assumptions about the future and successful planning involves asking whether your assumptions are realistic. You also have to consider how your lifestyle might change if future economic and financial conditions are much different than projected. Many retirement assumptions are based on historical numbers, but there is no certainty that future portfolio returns will resemble the past. This is why investors should think in terms of probability, not history.