You have decided to retire but need to manage your retirement portfolio with an eye toward an asset withdraw strategy. You have been busily contributing to your retirement plan and savings using an asset allocation that meets your objectives. But you now need a withdraw strategy that doesn’t upset your portfolio’s allocation and expose you to an inappropriate level of market risk. In other words, you have questions on how to structure your retirement asset accounts and which ones should be used for withdrawals.
I describe two methods – the bucket approach and the total portfolio approach – that many retirees use. Both methods guide your portfolio management and asset withdraw strategies. Which method you choose, however, depends upon which approach you feel most comfortable setting up and executing on a sustainable basis.
How Much Cash Do You Need?
Before you determine which method to use, let’s review how much you need to withdraw. This amount is the difference between your retirement cash inflows and your cash outflows. The shortfall, if there is one, is the amount you need to withdraw from your retirement assets. I will call this amount your “annual withdrawal amount.”
1. Determine Your Retirement Cash Inflows or Income
Retirement cash inflows can come from multiple sources: your pension, Social Security, part-time work, and real estate rents. It is critical to know how much is guaranteed to arrive each month or year. This amount is your cash inflow. Do not include investment earnings (bond or CD interest or stock dividends) because these monies are more variable in nature and are dependent upon how your assets are invested. These monies will be included in the strategies below, but they are not a guaranteed source of income.
2. Determine Your Cash Outflows
In a previous blog I described two ways to figure out your cash outflows each year: a top down approach or bottom up approach. Both approaches provide an amount that represents your annual spending or cash requirement. This amount should include your housing (mortgage, property tax, etc.), fixed (income taxes, health insurance premiums, etc.), and living expenses (food, entertainment, travel, etc.).
Keep in mind that recent consumer research shows that spending during retirement isn’t necessarily level each year. Often more cash is spent in the early years of retirement on travel, home renovations, etc. Spending in the middle years can decrease as you stay put a bit more and your activity level decreases. The third phase is the wild card. At this point, retirees spend very little or they spend a lot on health care costs, including long-term care. Notwithstanding these facts, the idea of determining your cash outflows can be revisited as you go through retirement and your annual spending needs change.
3. Cash Outflow – Cash Inflows = Withdrawal Amount
Subtract the inflows from the outflows. The result will be your annual “withdrawal amount.” In other words, this is the amount you need to withdraw from your retirement assets annually.
If the withdrawal amount is a negative number, you don’t need your retirement assets to maintain your current spending level. For example, if your outflows are $75,000/year and your inflows are $80,000 then you will have excess cash of $5,000/year. You have more flexibility on how to invest your retirement assets. You can be aggressive or conservative depending on your future plans or your estate needs and desires.
If the withdrawal amount is a positive number then it represents the amount to withdraw from your retirement assets. For example, if your outflows are $70,000 and your inflows are $50,000, then your annual withdrawal amount is $20,000. The two methods below describe alternative ways to reorient your retirement portfolio in order to withdraw this $20,000 from your retirement asset accounts.
4. One Further Consideration: Essential versus Discretionary Cash Outflows
If your annual withdrawal amount is large, you may want to examine your outflows a bit further. Separate your annual cash outflows into two types: essential and discretionary spending. Essential spending includes housing, utilities, taxes, insurance premiums, food, transportation, and other basic needs. Discretionary spending includes travel, entertainment, food (beyond a basic amount), and any other spending that you can get by without.
Redo step three to see if your retirement inflows exceed your essential spending. If so, then you won’t have to worry about meeting your essential spending each year or month. If not, then you may want to consider purchasing an immediate annuity that, along with your other retirement income, meets or exceeds your essential spending amount. You don’t want to have to worry about whether you can pay the mortgage or buy food while you are in your golden years. The other benefit of this approach is that you can vary your withdrawal amount based on market performance (but more of this idea is below). The key point is to know what spending is essential and what isn’t.
The first approach uses three buckets to manage your retirement portfolio. The bucket concept is based on the premise that assets needed to fund your near-term withdrawal amounts should remain in cash so you can get to it easily with little or no risk that the amount will decrease. Assets that won’t be needed for more than five years can be invested for the long-term, with the cash buffer providing the peace of mind to get through any market downturns. A really helpful Morningstar article further describes this approach. It is briefly summarized here.
Bucket 1 contains the one to two years of your annual withdrawal amount. This amount will be held in cash (your savings account, a short-term CD, or a short-term bond fund). The amount you hold in bucket 1 depends on your risk tolerance. Maintain two to three years of your withdrawal amount in bucket 1 if you want to take the worry out of whether you won’t have enough to live on.
Bucket 2 contains three to five years of your annual withdrawal amount invested in high-quality bonds (bond funds) or dividend-paying blue chip stocks/stock funds. The income produced from bucket 2 can be used to replenish bucket 1 and not automatically reinvested into the same assets in bucket 2. The total amounts in buckets 1 and 2 provide you anywhere from five to eight years of annual withdrawal amounts in low volatility assets.
Bucket 3 is invested in a broadly diversified portfolio of stocks (domestic and international), REITs, and more volatile bond types such as junk bonds. This portion of the portfolio is likely to deliver the best long-term performance. It will be, however, the most volatile of the three buckets. Buckets 1 and 2 can be used to ride out the ups and downs of bucket 3. Like the dividends and interest payments from bucket 2, the dividends and interest payments from the assets in bucket 3 are not automatically reinvested, rather they are paid right into bucket 1.
During retirement, first go to bucket 1 for your annual withdrawal amount. Once bucket 1 starts to run low (less than 1 year left of the annual withdrawal amount) then it is time to rebalance your overall portfolio. You can sell some of the assets in buckets 2 and 3 in a proportion that gets you back to your original allocation of two-three years in bucket 1 and three-five years in bucket 2. At the end of the rebalance process, bucket 3 will be smaller because 1 and 2 will be bigger. The key here is to examine periodically (such as quarterly or every six months) whether to replenish buckets 1 and 2 from bucket 3. You don’t want to sell assets in bucket 3 when their value has decreased. Thus, the amounts in buckets 1 and 2 can be used to get you through the downturn in bucket 3.
One practical point in this method is to consider using different accounts for buckets 2 and 3. For example, you may want to use your old employer’s 401k as bucket 2 and your IRAs as bucket 3. This way the buckets are at different institutions and are easier to maintain.
Total Portfolio Approach
The second method to manage your retirement asset portfolio uses systematic withdraws from your portfolio to fund your annual withdrawal amount. Maintain one to two years of the annual withdrawal amount in cash (checking, short-term CDs, short-term bond funds) similar to the bucket method above. The remainder of your retirement portfolio should be invested in a diversified portfolio using an asset allocation that matches your risk tolerance (e.g., 60% equities / 40% bonds). The dividends and interest payments from the portfolio should be automatically reinvested (similar to the way you’ve done so during the accumulation phase while you were working).
The key to this method is to take a systematic withdrawal at defined periods (e.g., monthly, quarterly, or annually) and to rebalance the remaining portfolio after the withdraw back to its initial asset allocation. Say for example that you initially set your $600,000 portfolio with a 60% equity ($360,000) and 40% bond ($240,000) allocation. Your annual withdrawal amount is $20,000. When the time comes to take your annual withdrawal, your portfolio is now $370,000 in stock funds and $235,000 in bond funds for a total of $605,000 (an increase of $5,000).
To determine the proportion of the $20,000 to take from your stock and bond funds follow two steps: (1) determine the after withdrawal value of the stock and bond allocations, and (2) subtract this value from the current value to get the amount to take out of the stock or bond accounts. The math is below:
1. Stock allocation after withdrawal ($605,000 – $20,000) x 60% = $351,000
2. Stock withdrawal = Current stock value ($370,000) less value after withdrawal ($351,000) = $19,000
So this means of the $20,000 needed for the withdrawal, $19,000 will come from your stock funds. Do the same thing with your bond accounts.
1. Bond allocation after withdrawal ($605,000 – $20,000) x 40% = $234,000
2. Bond withdrawal = Current bond value ($235,000) less value after withdrawal ($234,000) = $1,000
Your bond fund withdrawal will be $1,000.
This example shows that you sold your winners (the stocks which had risen) and sold very few of your bonds (which had decreased in value). After the withdraw is complete, your retirement portfolio is back in balance of 60% stocks and 40% bonds.
Both of these methods – the bucket method and the total portfolio method – are tried and true. The one that you choose depends on which makes most sense to you. Remember to revisit your retirement portfolio management and your asset withdraw strategy periodically as your spending levels change during retirement. The critical point is that you need to manage your retirement portfolio with an eye towards an easy to use asset withdraw strategy.