Of the many challenges facing retirees, building an investment portfolio that can generate income for as long as you live is one of the most important. And increasingly, that means planning for decades.
Investing for Retirement
According to recent data from the Society of Actuaries (SOA), a healthy 65-year-old today has a meaningful chance of living well into their late 80s or 90s. Roughly half of 65-year-olds can expect to live beyond age 85. The probability of reaching age 90 is no longer a remote possibility — it’s a realistic planning scenario.
For married couples, longevity risk becomes even more significant. When both spouses are age 65, there is a strong likelihood that at least one will live into their 90s. In many cases, retirement may last 25 to 30 years or longer.
These aren’t just statistics — they are essential inputs when designing a retirement income strategy. Because when retirement could span three decades or more, your investment approach, withdrawal strategy, and risk management decisions must be built to last.
Review Your Investments for Risk and Return
When you first retire — and periodically throughout retirement — you should review the allocation of your investment portfolio as a whole, including all of your retirement plan, IRA, and other invested assets. As part of these periodic reviews, consider the level of risk your current portfolio carries. Make sure that your asset allocation is appropriate for your personal situation.
Remember, all investments involve risk — in varying degrees. Generally, stocks are considered riskier than bonds, which are considered riskier than cash alternatives (certificates of deposit, U.S. Treasury bills, and similar short-term securities). The greater an investment’s risk, the greater its potential return.
Ask yourself how much risk you can afford to take at this point in your retirement. If you’ve been retired a while, your current risk tolerance may be different than it was when you first retired and different than it will be later on. If you have a substantial portfolio, you may be able to accept more risk than someone with very limited assets who has more to lose in terms of financial security.
Focus on Income
Investing in fixed income and cash alternative investments can provide you with a steady stream of income to supplement regular income you may receive from Social Security and pension plans. You can choose from:
- Bonds or bond funds1
- U.S. Treasury bills
- Money market funds2
- Certificates of deposit (CDs)3
- Bank savings accounts
- Annuities4
- Dividend-paying stocks5
Investing in multiple investments rather than one investment type or one fund can help soften the impact of unfavorable interest rate and price changes. When interest rates fall, newly issued bonds and CDs pay a lower rate of interest than older ones. Consequently, the values of older bonds with higher rates increase. The opposite happens when interest rates go up. The yields you receive on money market funds and deposit accounts also fluctuate with interest rate changes.
Bond funds. Investing in bond mutual funds1 can help you take advantage of interest rate changes. Fund managers buy and sell individual bonds as needed to pursue their funds’ objectives and seek better returns. Managers also buy bonds with different maturities in an effort to increase returns and provide more consistent income.
Laddering. Another potential strategy to generate more consistent income is to “ladder” your bond and CD investments so that they don’t all come due at the same time. With laddering, you buy multiple bonds and CDs with staggered terms. When an investment matures, you reinvest the principal at the longest term of your ladder. That way, you can take advantage of any increases in interest rates and avoid a sudden, across-the-board decrease in your bond and CD income when interest rates drop.
You will also have greater liquidity if you always have a bond or CD that’s near maturity. Laddering may help you avoid potential losses or penalties that could arise if you had to sell a bond or cash in a CD early to meet your cash flow needs.
Leave Room for Growth
Over the years you are retired, even modest inflation could significantly increase your income requirements. To keep pace and to meet potentially higher health care costs later in retirement, you should consider investing some of your retirement assets for growth. Generally, that means including stocks5 in your portfolio. While past performance is no guarantee of future returns, historically stocks have outpaced inflation by the widest margin compared to other asset classes and produced the highest long-term returns.
Set Your Asset Allocation
Once you’ve assessed your tolerance for risk and determined your optimal asset allocation, you should review your current allocation to see how closely it matches the portfolio that is appropriate for your situation, including your income and growth needs. If your current allocation is off significantly or doesn’t address those needs, you probably should change your allocation. You don’t have to make the changes all at once. In fact, gradual change is often a better way to go.
Let’s say you determine that you should have more of your assets in fixed income investments. You might move a certain percentage of your stock investments into fixed income investments each quarter until you achieve the allocation you want. Once you’re happy with your investment mix, periodically reassess it to make sure it’s still in line with your risk tolerance and income requirements. Many financial professionals recommend that you review your asset allocation and make any necessary changes at least annually, but not more than quarterly.
Strategies for Spending During Retirement
One of the biggest mistakes a new retiree can make is to withdraw too much too soon. Consider that if you withdraw 10% of the initial account balance each year from an investment portfolio earning an average annual return of 5%, you’ll deplete your savings in 15 years. If you withdraw only 5% from the portfolio, your savings will last indefinitely because you won’t deplete any of your principal. You need to balance your return expectations and tolerance for risk against your income needs.
The 4 Percent Rule
A well-known retirement spending strategy is the “4 percent rule.” It was introduced in the 1990s by now retired financial planner William P. Bengen. The author of “Conserving Client Portfolios During Retirement” calculated a sustainable withdrawal rate that can be maintained for 30 years in retirement (adjusted for inflation).
For example, a retiree with a $1 million portfolio would calculate the first year withdrawal as $1 million x 4 percent = $40,000; assuming an inflation rate of 2.5 percent, the second year withdrawal would be $40,000 x 1.025 = $41,000 (and so forth).
This simple rule of thumb, however, is not without its shortcomings. First, Bengen’s research looked at historical market returns dating back to the 1920s.
Today, experts note, returns aren’t likely to be as robust as in the past. As a result, a lower, more conservative, spending rate (such as 3 percent) may be more appropriate. Second, the rule was calculated on spending 30-years in retirement. As increasing numbers of retirees are living longer, that 30-year yardstick may no longer be prudent. Third, the “4 percent rule” does not take into account the sequencing of market returns. So, those who experience negative portfolio returns, early in retirement, may have to adjust their spending to avoid prematurely depleting their portfolio’s assets.
Dynamic Spending
For some retirees, employing a dynamic spending strategy can be helpful. Utilizing this strategy, retirees set a target annual spending amount, establishing a ceiling percentage to increase spending after a year of notable portfolio returns and a floor percentage to decrease spending after a year of poor/negative portfolio returns.
Employing this approach, retirees can adjust portfolio withdrawals (higher or lower) based on performance, which may help preserve the portfolio’s assets compared to a fixed withdrawal rate. Among the drawbacks of this strategy include the retiree being able to calculate a reasonable spending range and variable spending over-time based on market/portfolio performance. Behavioral finance suggests a retiree would increase spending following positive returns but reluctant to reduce spending after negative returns.
The Bucket Approach
In recent years, the “bucket approach” has grown in popularity among financial planners. With this approach, a retiree designates a pool of assets (the bucket) to help achieve their retirement income goals within a defined period of time.
For example, the first bucket could be for short-term needs (less than 3 years), with the pool of assets allocated very conservatively among cash and bonds. A second bucket, for intermediate needs (3 to 10 years), has a longer time horizon. That bucket would be invested among bonds, stocks and real assets. The third bucket would be for long-term needs (10-plus years) and have a smaller allocation to bonds with a larger allocation to high-growth assets including stocks, real assets and alternative investments. Over time, as assets in the first bucket are depleted, they are replenished with a transfer from the second bucket that is replenished with a transfer from the third bucket.
From a behavioral finance perspective, retirees may be better equipped to handle market volatility with their assets segregated. In the event of a prolonged market pullback, a retiree’s near-term cash needs are covered with the first (short-term) bucket. The drawback of this strategy is it can complicate a thoughtfully constructed portfolio. Also, many retirees have multiple investment accounts (both taxable and tax-deferred) that monitoring and evaluating each bucket could be viewed as unwieldy.
Understand Monte Carlo Simulations
Named for Monte Carlo and modeled after the chance and random outcomes associated with the gaming destination, Monte Carlo simulations were developed in the 1940s by mathematician Stanislaw Ulam.
A Monte Carlo simulation incorporates a number of variables (savings, spending, asset allocation, market returns, taxes, etc.) to project the probability a retiree will have sufficient assets throughout retirement. Ideally, the Monte Carlo simulation shows a high projected probability of success (such as 80 percent or more), which will provide some cushion should future results vary from initial inputs. If the Monte Carlo simulation projects close to 100 percent, the retiree could reassess the analysis and use a higher spending rate; conversely, if the projected probability is too low, the retiree would need to adopt a lower spending rate.
The simulations have advantages, most notably the analysis can incorporate a wide range of variables to determine if there are enough assets for a given spending level. The Monte Carlo simulations have great flexibility to assess how changes to selected variables (savings, spending, returns, etc.) affect the distribution of retirement outcomes. As for its potential limitations, if the simulation model’s annual spend rate is too low or future asset returns too high, the analysis usefulness could be limited.
Prepare for Your Retirement, Today
Retirement is a process, not an event or a destination. Thoughtful preparation must be exhibited to determine the appropriate annual spend. Equally as important, is an ongoing discussion of the retiree’s long-term needs and goals. Each should be revisited periodically and reassessed to provide a successful retirement. Ready to discuss reaching your retirement goals? Give us a call at 800-650-9474 or contact us through our website.
1 Prices of fixed income securities may fluctuate due to interest rate changes. Investors may lose money if bonds are sold before maturity. You should consider a mutual fund’s investment objectives, charges, expenses, and risks carefully before you invest. The fund’s prospectus, which can be obtained from your financial representative, contains this and other information about the fund. Read the prospectus carefully before you invest or send money. Shares, when redeemed, may be worth more or less than their original cost.
2 An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although the Fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in the Fund.
3 Bank CDs are insured and offer a fixed rate of return, whereas both principal and yield of securities will fluctuate with changes in market conditions.
4 An annuity may impose charges, including but not limited to surrender charges, mortality and expense risk charges, administrative fees, underlying fund expenses, and feature charges that can reduce the value of your account and the return on your investment. You will have to pay federal income tax on any earnings you withdraw from the annuity during retirement or before. Payments and guarantees are subject to the claims-paying ability of the issuing insurance company and the underlying investment options are subject to market risk and may lose value.
5 Stock investing involves a high degree of risk. Stock prices fluctuate and investors may lose money.
The general information provided in this publication is not intended to be nor should it be treated as tax, legal, investment, accounting, or other professional advice. Before making any decision or taking any actions, you should consult a qualified professional who has been provided with all pertinent facts relevant to your particular situation. This publication was prepared for the publication’s provider by an unrelated third party, SS&C Retirement Solutions, LLC. The content was not written or produced by the provider.
