Investing to Make your Retirement Savings Last through Retirement


 There are actually three things that funds must be protected against in retirement.  The first is that the value of the portfolio may drop due to market fluctuations.  The second is that the portfolio be exhausted through spending before the end of one’s life.  The third is that inflation wastes away the value of the portfolio, forcing one to lower one’s standard of living.

Protecting a portfolio against drops in value is done through 1)holding sufficient reserves in cash (money funds and CDs) to pay for near-term expenses, and 2) diversification for money not needed immediately.  Money that will be left alone for many years should be invested in assets that provide a sufficient return to make up for inflation, such as stocks, bonds, and real estate.  But because the stock market (and bond market and real estate market) has good years and bad, it is not safe to be fully invested when money will be needed for expenses.  One does not want to need to withdraw money from the stock market just after a big sell-off to pay for living expenses.  For this reason money needed for the next five years should be kept in cash instruments.  Looking at the 2008 bear market, one would have been in bad shape if one needed to sell stocks at the end of 2008 to pay for food and rent, but if funds remained invested while other cash reserves were spent the losses experienced in 2008 would have been largely erased by the strong rally of 2009.

For money not needed immediately, say money that will not be needed for the next 5-10 years, keeping these funds in cash instruments will cause spending power to be lost to inflation.  These funds should therefore be invested in common stocks, bonds, and real estate (either directly or through REITs).  These funds should be well diversified – spread over several different mutual funds, types of assets, and areas of the market – to reduce the risk of large losses in value.  The goal here is not to beat the market but instead to simple make market returns while reducing the chances of loss of capital as much as possible.

A good rule-of thumb to prevent exhausting one’s funds is to not spend more than about 8% of the value of a portfolio during any given year.  (Note that this allows one to calculate the amount of money one needs to save up for retirement.  If one can spend up to 8% of the value of the portfolio each year,  one’s savings should be about 12 times the needed yearly income in retirement.)  To understand this withdrawal rate, assuming that the portfolio will grow at about 10-12% each year (the historical growth rate for equities), as long as no more than 8% of the portfolio is withdrawn during any given year, the return of the portfolio should be enough to provide sufficient income and make up for losses due to inflation.

An issue with the above methodology, however, is that while the average return for a diversified portfolio of stocks is 12%, this includes some great years in which the market surges 30% and some bad years when the market falls by 10-15%.  A better strategy would be therefore to:

1) Determine how much yearly income is needed for yearly expenses and start with five years worth of cash-on-hand.

2) In years when the portfolio increases in value more than 4%, take money out any amount over the 4% growth rate.  For example, if the portfolio increases in value by 10% in a year, 6% could be withdrawn.  This would be done until ten years-worth of expenses are in cash-in-hand,

3) On years when the portfolio value is not up at least 4%, do not take any money out unless less than 3 years-worth of expenses is available in cash-in-hand.   In that case enough money would be withdrawn to regain five years’ worth of cash.

By following this strategy one would be able to sell when the market is high but still maintain enough cash-in-hand to ride out any down years.  This should keep one’s initial assets intact while providing enough income from those assets for living expenses.

Note that living expenses should include 1)health care expenses, 2) food, clothing, and utilities (hopefully shelter will be paid for), 3) upgrades and repairs to the house and purchase of cars, 4) money for any leisure activities or travel, and 5) long-term care insurance.

Please contact me via vtsioriginal@yahoo.com or leave a comment.

Follow me on Twitter to get news about new articles and find out what I’m investing in.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. 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. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

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