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How to Invest When You’re Retired
Your Investing Needs Change in Retirement The act of retiring drives key financial changes Money stops flowing from your income to your portfolio and starts flowing the other way. Your investments need to cover short term costs and preserve your long term purchasing power. “Waiting out” a rough patch in the market or recovering from losses both get tougher to do if you need to sell investments from your portfolio to cover your costs.
Your Objective: A Careful Balancing Act To address those different needs, split your portfolio into three parts based on when you’ll need the money: Short term: Cash (Easy to spend, always worth its face value.) Mid term: Bonds (Typically better interest than cash to help fight inflation, more certain payouts than stocks to help preserve value.) Long Term: Stocks (Opportunity for long term real growth to help the portfolio maintain purchasing power over your lifetime, but far less certainty on any given day.) Source: pixabay.com
Reaching that Objective: A Laddered Portfolio Source: pixabay.com Cash 6-12 months of expenses Bonds 7-10 years of expenses Stocks Everything else Each part plays its role: Stocks: Long term growth potential, though with little short term certainty. Bonds: Buffer against stock volatility, convert to cash at maturity, and some income along the way. Cash: Spending money.
How Much Do You Need, and Why? A decent estimate is that you’ll need 25 times the amount of money you expect to withdraw from the portfolio to spend in its first year. At that level, you’re covered by the 4% Rule, a classic rule of thumb in retirement investing. In essence, the 4% rule says that, if you: Invest via a well structured, diversified portfolio Withdraw up to 4% of the portfolio’s value in its first year Increase your withdrawals every year in line with inflation …then your money will very likely be able to last for your retirement.
Matching the Theory to Real Numbers Imagine a fairly typical couple approaching retirement. Annual household income: $53,000 (about the US median) They had been saving for retirement, so between no longer paying Social Security taxes and no longer saving for retirement, they think they can live comfortably on 75% of that income level, or $39,750 per year. They’re expecting about average Social Security benefits, based on a one-wage-earner household: Employed spouse: $1,328/month ($15,936/year) Spousal benefit (50%): $664/month ($7,968/year) The portfolio needs to cover $15,846 in year 1 expenses. We’ll round up to $15,900 for this example to make the numbers easier to follow.
Other Key Assumptions for This Example The example also assumes: Both spouses are at their normal Social Security retirement age A solution to Social Security’s long-run funding problems will be found The couple has no extraordinary expenses or special health risks When one passes, the surviving spouse’s expenses will decrease by the amount of the smaller Social Security check Inflation will average 3% per year, about in line with longer term trends The needed bonds can be bought at prevailing interest rates at par value
Building the Ladder Source: pixabay.com Cash: $15,900 1 Year Bond: $16,400 Stocks: $255,900 2 Year Bond: $16,900 3 Year Bond: $17,400 7 Year Bond: $19,600 6 Year Bond: $19,000 5 Year Bond: $18,500 4 Year Bond: $17,900 Total Starting Value: $397,500: 25 times the first year’s spending that the portfolio has to cover. Important building blocks: Cash to cover near term expenses Bonds that: Mature each laddered year Will provide the next year’s cash, adjusted for expected inflation Are laddered deep enough in maturity years to absorb typical market fluctuations over time Stocks that: Are enough of a presence so that in a typical market year, some can be sold to reload the top of the bond ladder, while the rest can continue to grow
Reminder: Strong Investing Principles Matter As a retiree, you can’t afford weak rungs in your ladder. Consider high quality bonds like: US Treasury or Agency Bonds Insured municipal bonds A diversified mix of “A” rated or better investment-grade corporate bonds Consider intelligently diversified, low-cost stock funds like: S&P 500 or Total US market index funds Total World or Total Developed World index funds Keep your cash liquid and safe: Checking, savings, or money market Source: pixabay.com
Using the Laddered Portfolio – an Ordinary Year Cash: $15,900 1 Year Bond: $16,400 Stocks: $255,900 2 Year Bond: $16,900 3 Year Bond: $17,400 7 Year Bond: $19,600 6 Year Bond: $19,000 5 Year Bond: $18,500 4 Year Bond: $17,900 Cash: $16,400 1 Year Bond: $16,900 2 Year Bond: $17,400 3 Year Bond: $17,900 6 Year Bond: $19,600 5 Year Bond: $19,000 4 Year Bond: $18,500 Interest: $36.08 Interest: $99.71 Interest: $167.04 Interest: $215.69 Interest: $268.25 Interest: $304.00 Interest: $343.00 Dividends: $4,875.33 Spent to Cover Expenses Cash Generated: $6,219.10 Bond Yields based on US Treasuries, Stock Yields based on SPY, as of Jan. 9, 2015 Stocks: $271,254 The starting cash gets spent to cover expenses The bonds generate interest and get one year closer to maturity The stocks pay dividends and have a chance to grow Cash Generated Year 1 Starting Point Portfolio at the end of year 1, assuming 6% stock gains
Topping off the Ladder – an Ordinary Year Cash: $16,400 1 Year Bond: $16,900 2 Year Bond: $17,400 3 Year Bond: $17,900 6 Year Bond: $19,600 5 Year Bond: $19,000 4 Year Bond: $18,500 Stocks: $271,254 Generated Cash: $6,219.10 Cash: $16,400 1 Year Bond: $16,900 2 Year Bond: $17,400 3 Year Bond: $17,900 6 Year Bond: $19,600 5 Year Bond: $19,000 4 Year Bond: $18,500 End of Year 1 Portfolio 7 Year Bond: $20,200 Stocks: $257,273.10 Start of Year 2 Portfolio Use the cash generated by the portfolio and sell some of the stocks to buy back that 7th year of bonds in the bond ladder. Source: pixabay.com Repeat the process every year that the stock market has about normal returns, throughout retirement.
What if the Stock Market Has a GREAT Year? Cash: $16,400 1 Year Bond: $16,900 2 Year Bond: $17,400 3 Year Bond: $17,900 6 Year Bond: $19,600 5 Year Bond: $19,000 4 Year Bond: $18,500 Stocks: $307,080 Generated Cash: $6,219.10 Cash: $16,400 1 Year Bond: $16,900 2 Year Bond: $17,400 3 Year Bond: $17,900 6 Year Bond: $19,600 5 Year Bond: $19,000 4 Year Bond: $18,500 End of Year 1 Portfolio (assumes 20% stock gains) 7 Year Bond: $20,200 Stocks: $272,299.10 Start of Year 2 Portfolio 8 Year Bond: $20,800 Source: pixabay.com If stocks have a great year, sell more from the stock portfolio to add another year to the bond ladder. This increases the buffer against the next market downswing. Another option: Add more to each of your existing bond levels & spendable cash. This would help you protect against faster than expected inflation or see your income increase in real terms.
What if the Stock Market Has a BAD Year? Cash: $16,400 1 Year Bond: $16,900 2 Year Bond: $17,400 3 Year Bond: $17,900 6 Year Bond: $19,600 5 Year Bond: $19,000 4 Year Bond: $18,500 Stocks: $204,720 Generated Cash: $5,000 Cash: $16,400 1 Year Bond: $16,900 2 Year Bond: $17,400 3 Year Bond: $17,900 6 Year Bond: $19,600 5 Year Bond: $19,000 4 Year Bond: $18,500 End of Year 1 Portfolio (assumes 20% stock losses & dividends that get somewhat cut) Stocks: $209,720 Start of Year 2 Portfolio Source: pixabay.com If stocks have a bad year, invest the cash your portfolio generated back into stocks, instead of in bonds, and let the bond ladder decrease by a year. Important Note: Only invest money in stocks that you don’t need to spend for at least 5 years. Starting with 1 year of cash & 7 years of bonds gives you some, but not unlimited, flexibility to let the stock market recover from a downturn.
What about the bonds? This laddered portfolio uses bonds in a way that reduces direct exposure to the interest rate and volatility risks associated with bond investing. It still depends on the bond issuer remaining solvent. Key ways it reduces exposure to those risks: Interest is reinvested, rather than used for current income Bonds are held to maturity rather than sold early Maturing bonds become the next year’s spending cash New bonds are bought with expected inflation in mind. The longer term bonds are all bought to mature at higher balances so the next year’s spendable cash increases with expected inflation.
Balanced Risks -- Solid Chance of Success Source: pixabay.com Short term: Cash Mid term: Bonds Long Term: Stocks No strategy can completely eliminate all risks. By balancing the risks of different investment classes with the short and long term needs of a retiree, this laddered approach provides a solid chance of success over a retiree’s life span.
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