Investing During Retirement
by Scott Houser with Mark Biller
May 11, 2005
(AgapePress) - The cartoon shows a man sitting at his kitchen table, coffee cup in hand, looking over his retirement statement. The caption reads: "According to your latest figures, if you retire today, you could live very, very comfortably until 2:00 p.m. tomorrow." Accumulating enough money for a comfortable retirement doesn't happen by accident. And procrastination carries a heavy cost. On the other hand, developing a realistic long-term plan that takes into account your financial needs and personal goals provides tremendous benefits.For most of us, the likelihood of enjoying our preferred lifestyle during retirement is heavily dependent on steps we take years before we move into that season of life. The following three financial steps are among the most important you can take before reaching retirement to help guarantee that your retirement lifestyle will meet your expectations.
1. Be completely debt-free at your target retirement age. This includes your home mortgage and any college debt you may have incurred for your children. Debt, especially a high mortgage payment, limits investment options and lifestyle flexibility. If you need to add additional principle to today's monthly mortgage payment to pay it off by retirement, do it!
2. Maximize your contributions to your company's retirement plan, such as a 401(k). Hopefully you realize that Social Security will not meet 100% of your retirement needs. Public policy continues to move towards individuals becoming increasingly more responsible for funding their own retirement. The tax-deferred investment growth and savings discipline that occurs inside your company's retirement plan is hard to beat. Contributing to an IRA is also a good idea, especially if you're already taking full advantage of any matching within your company retirement plan.
3. Establish a savings/emergency fund. In other words, build your personal liquidity. Why is this important? First, it buys you time. Personal savings will allow you to postpone tapping into your retirement savings for monthly living expenses after the paychecks stop coming in. You will have adequate time to reposition your retirement investment assets, if necessary, and let them continue to grow tax-free. Second, it provides efficiency. If you need $20,000 for a new car, you won't have to take $30,000 out of your retirement funds, pay $10,000 in income taxes, and then have $20,000 left to spend for a car. Again, this allows your long-term investments to continue growing tax-deferred.
A 'Total Return' Approach
"How am I going to replace that monthly paycheck?" is frequently the first question a newly retired person has. But, is it the right question to ask first? We believe it's merely one of a series of questions that, correctly answered, lead to good investment decisions. Instead of focusing immediately on income, a more appropriate starting point is determining which is a greater concern to you -- the short-term risk of market volatility and potentially losing principal in the short run, or losing purchasing power to inflation over your retirement lifetime?
If you're uncomfortable with the idea of ever losing any money, then fixed-income investments (e.g., bank certificates of deposits, money market funds, Treasury bills and notes, short-term bonds) are the most appropriate investment vehicles for you. However, people are retiring earlier and living longer, and all but the very wealthy need to continue to invest some money in stocks in order to keep up with inflation.
A retired investor has to weigh the importance of two competing desires. One is the desire to minimize portfolio volatility and not lose money, even over short time periods. If this is a major priority and you have a sufficiently large retirement nest egg, you can stick with income-oriented strategies and enjoy very little short-term volatility.
But for many, the more pertinent concern is not running out of money during your (or your spouse's) lifetime. If you're not likely to retire with enough money to simply "live off the interest," this means constructing a retirement portfolio that will grow with inflation and protect your purchasing power and life-style. That means continuing to invest a significant portion of your portfolio in stocks. But aren't stocks risky? The traditional answer is "yes." Stocks generally are more volatile than bonds. But because of inflation, volatility isn't the whole picture on risk.
Over time, inflation causes a static amount of money to essentially become worth less -- it erodes money's purchasing power. Purchasing power is also eroded when the cost of an item increases at a rate faster than inflation. For the past several years, medical costs have been the best example of an expense category rising faster than inflation. The $50 office visit five years ago now costs $100+. Other categories such as housing, especially in some high-growth geographic areas, have also risen much faster than inflation.
The solution then is to continue to invest part of your portfolio in stocks. But with stock dividends at such low levels, many retirees don't like that idea because stocks don't generate enough income. The ideal of "not touching the principal" and living off the interest of a portfolio can be difficult to shake. To get over this mental hurdle, we advise retirees to take a "total return" approach to their income needs. Purely from an income standpoint, would you rather own a bond that yields 5% or a combination stock/bond portfolio that yields 2%? The bond at 5% seems like the logical choice: earnings of 5% on $100,000 in bonds is $5,000 a year, while the 2% yield on the $100,000 stock/bond portfolio offers just $2,000 in income. But the amount of current income obtained from a particular investment shouldn't be the only thing considered in this decision.
Generally speaking, in three out of four years the total return (yield plus capital gains) from a stock portfolio will exceed the total return from an all-bond portfolio. What if, thanks to the stock holdings, the $100,000 stock/bond portfolio grew in value by 7% during the year? When you add the income of $2,000 to the appreciation of $7,000, the total return was $9,000 -- considerably more than the return from the bonds. But what if you need the full $5,000 of income to help meet your living expenses? Simply withdraw the difference from the stock/bond portfolio, selling some stock or bond fund shares as needed.
The table below gives two ten-year scenarios. In each case, an annual withdrawal is made that is adjusted upward to keep pace with a 3% rate of inflation (e.g., if income of $5,000 was desired initially, then $5,150 would be needed at the end of Year 1 in order to maintain purchasing power).
The "fixed income" strategy relies exclusively on bonds and CDs. An average rate of return of 5% is assumed. Note that this strategy falls behind almost immediately. The first year's withdrawal, after adjusting for inflation, is more than the amount earned. A small dollar amount of securities must be sold in order to fund the full payout. This leaves less remaining to invest in Year 2, resulting in a slightly greater shortfall that year. More securities must be sold to fund the payout. The cycle continues, slowly eating into the principal. Furthermore, the "ending balance" column in Year 10 doesn't tell the full story. After adjusting for 3% annual inflation, the principal's purchasing power is shown to be reduced to an even greater extent (far right column).
Now let's look at the "total return" portfolio consisting of 60% stock funds and 40% bond funds. Returns vary from year to year, but assume they average 9% per year over the entire decade. The first year all goes well, but stocks take a hit in Year 2, pulling the entire portfolio down. Securities must be sold (in such a way as to maintain the 60%-to-40% balance going into Year 3) in order to fund the payout. Briefly, the portfolio is looking worse than the fixed income strategy. What does the retiree do when his stock-oriented portfolio loses money? The first thing to remember is that you are investing for the long-term. Over the long haul, periods of ten years and longer, stocks have consistently produced positive results. Given life expectancies today, most retirees will live for 20-35 years off their portfolios, so a long-term perspective is appropriate.
At the end of the ten years, the stock/bond portfolio is worth $148,820 compared to $90,961 for the fixed income strategy. More importantly, it has maintained its purchasing power -- it's worth $110,736 in constant dollars. Even after adjusting for inflation, the account has 10.7% more purchasing power than it did when the strategy was launched. The important point to note is that the total return approach to investing still allows you to take a full annual withdrawal even in years when the market declined or did not return as much as the withdrawal rate. I used the 60/40 portfolio mix in the example because Sound Mind Investing recommends it for investors with five or less years until retirement assuming you can emotionally accept the risk.
Part 2: 'Retirement Cash Flow Strategies'
(Part 2 will be posted on May 12, 2005)
Published since 1990, Sound Mind Investing is America's best-selling financial newsletter written from a biblical perspective. To see how their specific saving and investing advice can benefit you, visit them online.
