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Lifetime Investing, Part One—The Retirement Income Phase – The Financial Preserve from Lonier Financial Advisory LLC
Conscientious Financial Planning and Retirement Income Management | 201-741-9528
from Lonier Financial Advisory LLC, Osprey, FL

Lifetime Investing, Part One—The Retirement Income Phase

Lifetime Investing, Part One—The Retirement Income Phase

There are all kinds of approaches to investing, from various long-term investing strategies to some pretty rarefied and/or hair-brained schemes for winning big by beating the market.  Managing savings and investments through employer sponsored plans and IRAs to meet a long-term retirement goal is the antithesis of fast money schemes aimed at beating the market for big gains.

In the next several posts, I will discuss the approach to saving and investing I take as a goal-oriented lifetime planner where winning is defined as creating a securely funded retirement.

There are four phases to a lifetime savings and investment plan:

  1. Savings Phase (accumulation). This is the 30-40 year period when you create your life’s savings through regular withholding from your paycheck into employer sponsored 401(k)/403(b) and IRA retirement and other taxable accounts.
  2. Downshifting Phase (transition) . This is the 5-10 year period before you plan to stop working. Traditionally this period was the period right before retirement, but increasingly the early period of retirement is a period of transition from a full-time career to part-time work or self-employment with lower earnings, that can extend into your 70s. Shifting gears means shifting things within your investment portfolio to align with your life changes.
  3. Retirement Income Phase (distribution). This is the potential 30-year retirement period where most or all of your expenses must come from your own savings, any pensions, and Social Security.
  4.  Legacy Phase. If you have planned well and have been fortunate, you may have more than you need for the rest of your life. Managing a legacy in most cases requires another shift, back towards a growth approach similar to the savings phase.

I’m going to start with the retirement income phase and work backwards. Understanding how the retirement income phase is managed helps clarify the phases leading up to it.

Asset Allocation
The most crucial decision an investor makes is how to divide up the household investment portfolio. At the highest level, the allocation between risky assets (stocks) and risk-free (Treasury bonds) and lower-risk assets (high quality corporate bonds) determines the overall risk of the portfolio.  Stocks are riskier but historically offer higher return—risk and reward are linked—while bonds historically offer both income and stability within a portfolio. This is especially critical in the retirement income phase, since market downturns can reduce the portfolio balance enough to leave you without sufficient funds to cover your fixed expenses. A risky allocation can literally put you in the poor house.

There are a number of ways different advisors use to allocate between stocks and bonds. Some use so-called risk tolerance questionnaires where scores are tied to conservative (30%/70%), moderate (50%/50%), and aggressive (70%/30%) stock/bond splits. Others use factors such as “age in bonds” to create a portfolio that shifts towards less risk with age. So-called target retirement funds use this kind of glide path.

All of these methods are arbitrary—a risk tolerance questionnaire does not accurately measure investor risk aversion, which often inversely rises and falls with the market. While a so-called 50/50 moderate portfolio might be made up of half stocks and half bonds, fully 80-90% of the portfolio risk comes from stocks. And people of all ages have different personal balance sheets, and so have different capacity for bearing the risk in their portfolio. An investor’s risk aversion is informed by how well the investor understands his or her own risk capacity.

The most prudent way to allocate between risky and risk-free assets in your retirement income phase portfolio—the only way that assures successfully funding your retirement—is to match the risk-free portfolio amount with the amount needed to fund your annual fixed and some level of discretionary expenses for the entire retirement period of 30 years.

Using Income Floor to Determine the Bond Allocation
In financial terms, the risk-free or bond part of the portfolio should equal the present value (PV) of all fixed and some level of discretionary retirement expenses—what we call the retirement income floor.  If the income floor is covered with risk-free assets, you won’t run out of money.

To do this, you need an accurate estimate of your annual expenses plus projected special expenses (new roof for the house, new cars, weddings, an emergency fund, etc), at retirement. Part of the downshifting phase as you near retirement is refining the broad estimates of retirement expenses used during the savings phase into increasingly accurate expense estimates at retirement that can be used to re-wire your portfolio.

For example, if your household Social Security and pension total will be $70,000/year and you need $120,000/year to cover fixed and some discretionary expenses, then the bond allocation of your portfolio should equal the 30-year present value of $50,000/year—the difference between $120,000 expenses and the $70,000 household SS plus pension. The 30-year PV of $50,000/year lightly discounted at 2% for today’s low return world is about $1,120,000. That means that the first $1.12 million of the portfolio should be in cash and bonds, and anything above that can be invested to the upside in stocks.

Based on your coverage ratio of savings-to-income floor, there are some adjustments to consider. If the total portfolio in this case is >$3 million (well-funded), then there is slim possibility of running out of money, and the entire portfolio can probably be managed as a phase four legacy portfolio similar to a savings phase growth portfolio.

If the PV of your annual income floor and your total portfolio values are within +/- 10% of each other, you are “constrained,” and need to make some adjustments—among them, purchasing some amount of annuity income to improve the safety of the income floor, delaying SS to increase the lifetime benefit (which is equivalent to buying an 8% annual increase in your SS “annuity” for each year of delay), working longer, cutting expenses, downsizing, and relocating. Until you have some cushion above the floor, say at least 10% of the value of the floor, you shouldn’t be in stocks at all.

If your portfolio doesn’t cover the income floor (under-funded), then even more of the above adjustments for “constrained” apply. Somehow you need to bring your expenses in line with your resources, including income from continuing employment.

In a low return world as today, the secure risk-free allocation covering the income floor may very well be a mix of cash, guaranteed CDs, and short-term Treasuries/TIPS. The more well-funded you are, the more flexibility you have and the more your retirement income portfolio—based on your income floor and not risk tolerance or age—will look like a conventional portfolio with sizable allocations to both bonds and stocks.

First Things First
To summarize, the key factors for successfully funding your retirement as you approach and enter into the retirement income phase:

  1. Savings rate—it’s never too late to add to your savings, but this should be a life-long focus, beginning as soon as you start working (savings phase), extending throughout the 30-40 working years before retirement
  2. Project and manage accurate expenses for the retirement income phase. Get spending under control if it hasn’t been
  3. Structure the retirement income portfolio so that the risk-free bond allocation equals the household retirement income floor (the PV of retirement expenses)
  4. Explore methods to improve you savings-to-income floor coverage ratio, such as delaying Social Security, purchasing low-cost simple income annuities, working longer, cutting expenses, downsizing to free up equity in your home, and relocating to a lower-cost area
  5. Note well that maximizing rates of return, picking stocks, researching the “best” funds, stretching for yield, investing in dividend winners, etc don’t make this list of key success factors

Now that we have a method for making the crucial determination of asset allocation for the retirement income portfolio, in the next post I’ll discuss the next level of portfolio management—diversifying away business risk within the bond and stock components, providing prudent exposure to market-level returns.

In the meantime, if you have any questions or comments, please let me know!

–Mike Lonier, RMA℠

Comments (1)

  1. Reply Andy

    Interesting and informative post. One question. How do you account for inflation. The bond/cash portion is determined by taking the PV of the gap between risk-free assets at a modest 2%. Historically, inflation has been higher than that (say 3%). Thus, in 30 years, your purchasing power be diminished.

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