The need for retirement planning doesn’t end with the onset of retirement. For those lucky to be a new retiree, you will now see a shift in your focus from building wealth to managing and preserving it. One major challenge as you enter this new phase is to make sure your investment portfolio can supply cash flow for the duration of your life—and through different economic and market conditions. This is where we become one of your greatest assets. Our knowledge and expertise allows us to build the roadmap that will guide you on your path to now enjoy those goals you set long ago.
Experts have studied portfolio longevity or endurance to help retired investors reduce the odds of depleting their wealth too soon. Studies reveal that three main elements act as the drivers for a portfolio’s ability to endure under the stress of changing markets and spending levels: asset mix, spending level, and investment time frame. 1 It probably does not come as a surprise to you that certain aspects of these factors are within your control while others are not.
Asset Mix – 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. This return premium reflects the higher risk of owning stocks.2 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. However, 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.
Spending Level – Portfolio withdrawal is typically described in terms of a specified dollar amount (e.g., $50,000 per year) or a percent of annual portfolio value (e.g., 5% of assets each year). Neither method is ideal, however—and for different reasons.
• Specified dollar amount: 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. One academic study quantified this amount. It found that a retiree with at least a 60% stock allocation can withdraw up to 4% of initial portfolio value (adjusted for inflation each year), and enjoy a high probability of never running out of wealth.3 Choosing a higher withdrawal amount is not likely to be sustainable, especially if the portfolio faces an extended period of negative returns.
•Percent of annual portfolio 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. This method can produce wide swings in your living standard when investment returns are volatile.
If you find that you need a relatively consistent cash flow you may want to combine these two methods; but first and foremost be sure to discuss this with us so we can help you put together the best approach.
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 bequeath assets, 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. Those with a longer investment time horizon might choose a higher exposure to equities. 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, you should think carefully about equity exposure and avoid taking more risk than you can afford.
Considerations – Planning involves assumptions about the future—assumptions that may not pan out. Although you cannot avoid making assumptions, you can ask whether they are realistic and consider how your lifestyle might change if future economic and financial conditions are much different than projected. Managing asset mix, payout, and time horizon inevitably involves tradeoffs.
Finally, although you cannot fully control these and other factors involved in portfolio endurance in retirement, having more wealth can improve the odds of having a less stressful financial life. A more substantial nest egg might enable you to take fewer risks, enjoy a higher sustainable spending rate, or extend the productive life of your portfolio.
1 Cooley, Philip L., Carl M. Hubbard, and Daniel T. Walz. 1998. “Retirement Savings: Choosing a Withdrawal Rate That Is Sustainable,” AAII Journal 20: 16–21. Also see: Bengen, William P. 1994. “Determining Withdrawal Rates Using Historical Data,” Journal of Financial Planning 7: 171.
2 From 1926 to 2009, the S&P 500 Index returned an average 9.8% per year compared to 5.4% for long-term government bonds and 3.0% inflation. Sources: Standard & Poor’s Index Services Group for S&P 500 Index; long-term government bonds and inflation provided by Stocks, Bonds, Bill, and Inflation Yearbook™, Ibbotson Associates.
3 Cooley, Hubbard, and Walz, Retirement Savings: Choosing a Withdrawal Rate That Is Sustainable,” 16–21.