Squam Lake Report
How do you define retirement? Are you planning to draw a sharp line between your career and your days of leisure, or do you expect a more gradual evolution? Either way, there will probably come a time when you begin to downplay building wealth and place greater emphasis on spending it and/or preserving it for future generations. For lack of a better word, we’ll call this post-transition period “retirement.”
In a big-picture sense, much of the planning that goes on with your wealth is in anticipation and execution of retirement – and it’s where your investment advisor can really earn his or her keep, to help you with the processes described below. The goal: to manage your portfolio’s endurance, i.e., its ability to supply a comfortable cash flow for the rest of your life – and to leave a legacy beyond that, if that is among your goals.
Three main factors drive portfolio endurance.
1. Asset Mix
Asset mix describes the ratio of stocks to bonds in a portfolio. While there have been numerous periods when returns have varied unpredictably across every asset class, over the long haul stocks have historically outperformed bonds and outpaced inflation. This return premium reflects the higher risk of owning stocks. Consequently, the larger your allocation to stocks, the greater your portfolio’s expected return – and risk.
Thus, if you can handle the risk, having more equity (stock) exposure in your portfolio enhances its return potential. Growth can bring higher cash flow, inflation protection, and portfolio endurance over time. That’s why most investors should have an equity component in their portfolio, but the actual amount depends on their unique time frame, risk tolerance and spending flexibility. As an advisor, one of the most important things I do is to help clients of all ages determine and implement the right asset mix for their enduring portfolio.
2. Spending Sweet Spot
How much can you safely withdraw from your portfolio, so you neither run out of money nor live more frugally than needed? As with most things in life there are different ways to go about answering the question, and each has their advantages and disadvantages.
Withdraw a specified dollar amount (such as $50,000 per year) – Withdrawing a fixed, inflation-adjusted dollar amount each year can provide a stable income stream, preserve your standard of living and give you a known value around which to plan your life. But if the markets don’t perform as well as hoped for, your portfolio may not be able to withstand the higher percentage being removed. Conversely in unusually strong markets, you may be able to afford to spend more, but needlessly limit yourself by sticking to a set amount.
Withdraw a percent (such as 5 percent of your annual portfolio value) – Withdrawing a fixed percent of your annual portfolio value makes it less likely you’ll deplete retirement assets, because you’ll accompany a sudden drop in market value by a proportional decline in your spending. On the other hand, percent withdrawals make it harder to plan your life from one year to the next, since it can produce wide swings in your living standard when investment returns are volatile.
Still, in most cases, I recommend the second option of percent withdrawal. While it’s a little more complicated on the planning side, I feel it more closely matches how life really works and thus gives you the most realistic spending guidelines. Ultimately, the more you can build spending flexibility into your plan, the safer your outcome will be.
3. Investment Time Frame
Your investment time horizon may be the hardest to estimate, especially if it is the same as your joint life expectancy (the timeframe needed to last until assets are eventually passed to heirs). In this case, you can only approximate how long your portfolio must support spending. If you plan to bequeath assets, your investment time frame may extend well beyond your lifetime, which may influence your risk and spending decisions as well.
It’s About You
Bottom line, planning involves making educated guesses about the future. And even highly educated guesses can be wrong. Thus, regardless of which withdrawal strategy you adopt or assumptions you make, it’s critical to do a periodic (approximately annual) reality check. Key decision points include determining when it may be necessary to cut back on planned spending; when it may be permissible to spend more freely than originally expected; and/or when it may be prudent to make adjustments to your portfolio’s asset allocation, to adjust your expected market risk and return up or down as appropriate.
So, yes, the markets play a big factor in your decision-making. But at the end of the day your portfolio’s endurance comes down to your own personal decisions in conjunction with your investment plan. How do you plan for your retirement? Though I can’t dictate your personal spending choices, I can help on the investment side to give you the highest probability of success.