Step 3 – Filling Your Buckets

After a brief interlude last week to update you about the third quarter, let’s return to the steps associated with backing into your asset allocation during retirement.

This post is part of series covering a multi-step process to 1) determine your annual spending needs in retirement; 2) use history as a guide to get a feel for how long a stock market downturn could last; 3) figure out how much to invest outside of the stock market to provide spending power during a downturn; and 4) how to reconcile all of this with the reality of your portfolio and tolerance for risk.

In our simplified example from Step 1 a few weeks ago we looked at a couple of retirees with a $15,000 spending deficit in the next year. They were planning to spend $90,000, including basic needs of about $75,000 plus $15,000 for discretionary spending (travel, painting the house and landscaping). They were expecting $75,000 of income. They’ve looked ahead and assume this spending rate will continue for the foreseeable future.

In Step 2 we looked at a downturn scenario where the stock market fell for almost two years and then took another two to recover. If our hypothetical couple wanted to be able to weather this kind of storm without altering their spending plans or going back to work, how could they do it?

This leads to Step 3, determining how much of your portfolio to keep out of stocks, and what to do with it.

The first decision for our couple is how conservative they want to be when planning for deficits. Do they want to use the actual amount of the deficit ($15,000) or their annual spending amount ($90,000)? This has direct implications on how much cash and other non-stock investments they plan to hold. For example, say they’d like to hold four years’ worth of spending needs outside of the stock market. Should it be four years of deficits totaling $60,000 or four years of spending needs totaling $360,000. The difference is huge, so let’s look at some of the considerations.

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Our couple expects to receive a big chunk of their income ($40,000) from Social Security. They also have some other income (let’s call it rental income) of $20,000. Add to this about $15,000 of investment dividends and they’ve covered $75,000 of their spending needs with predictable income.

Do they really need to have $360,000 at the ready when they have three sources of predictable income? Probably not. They could probably get by with much less. The reason is that even if the stock market went haywire and the economy slipped into recession, these income sources would likely continue. Yes, there’s concern about the health of Social Security and our tenant’s financial situation could change. We can also worry about dividend income from our stock and bond funds. But in reality, all three are pretty solid and should continue as planned.

Most people would probably prefer a larger cash cushion and simply opt to use a multiple of their annual spending needs as a target. But this oversimplification can lead to having too much in low risk/low return assets. While it’s prudent to have an additional emergency fund, say another year’s worth of spending deficit, too much can be too much. In other words, $360,000 for this couple could cover an additional 20 years of $15,000 deficits.

Where should the reserves be invested? The couple could put $15,000 into a money market and maybe a CD. The rest ($45,000) would go to high quality bond funds with a duration (a useful risk measurement for bonds) of no longer than four or five years. These two buckets (a short-term CD and shorter-term bond funds) would equal the desired four years of insulation from stock market volatility.

But a shorter-term set aside that’s too large relative to your portfolio could inadvertently crimp your growth potential. If stocks are expected to generate an average return of 7% and bonds and cash are expected to bring in 3%, you can imagine how much slower a portfolio would grow the more it has in bonds and cash. It’s simple math and there’s no way around it.

Here are a couple of examples –

$360K cash and short-term bonds within a $500,000 portfolio = 72% in cash and bonds with the rest in stocks. This allocation could be expected to return an average of about 4% per year.

At $60K this percentage drops to 12%, giving you lots of wiggle room to invest more in stocks for growth potential. This allocation could be expected to return about 6.5% per year on average.

The difference in return may seem small, but over a retirement of a couple decades or more it can mean the difference between success and failure. Which is right for you? What’s your minimum required rate of return? How much risk can you afford to take (or not to take)?

We’ll address these questions next week when we review Step 4, reconciling backing into your allocation with your actual portfolio.

Have questions? Ask me. I can help.

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