Shifting Your Investing Focus
During your accumulation years, your investing focus was primarily on long-term growth. The main goal for your portfolio is to earn an acceptable average annual return, while the emphasis was put on how much you saved each year.
But in retirement, the demands on your portfolio are likely to be very different. You are now withdrawing money from, not contributing money to, your investment portfolio. This requires a retirement income plan that balances your need for ongoing income with maximizing the likelihood of your savings lasting as long as you and your spouse may live.
What complicates things are the many factors that should be considered when creating your retirement income plan.
Factors to Consider When Creating Your Retirement Income Plan
- The Size of Your Retirement Nest Egg
- The Need for Income in Retirement
- Your Life Expectancy
- Your Spouse’s Life Expectancy
- The Anticipated Return From Your Investments
- The Anticipated Rate of Inflation
- The Effect of Taxes
As you can see, there are many assumptions to be made about future events when creating your retirement income plan. The longer we project into the future the less certain we can be about any outcome. We do not know how long we will live, nor know exactly what our future expenses will be. Also, the performance of the market is anything but consistent or predictable.
Determining Your Required Rate of Return
Now that you have determined how much retirement income you need to generate each year, you must invest in a way that allows you to continue to fill this income gap. Depending on your annual spending level, your investment portfolio will require a certain rate of return to maintain this standard of living over time.
Once you know what rate of return your personal savings need to generate, you can determine the appropriate mix of assets for your investment portfolio to attempt to earn the necessary rate of return. This may mean you pursue growth with a portion of your assets and the degree of risk that accompanies it.
How Should You Allocate Your Portfolio?
One way to determine how you should allocate your portfolio is using the Bucket Approach. In this method, you segment your portfolio based on your income needs over time. You would allocate your assets into one of three buckets; Now, Later, and Much Later.
The Now Bucket
Assets in the Now bucket should be in very safe assets such as cash or cash alternatives. Assets in this bucket should be liquid since they will be funding your living expenses within the next 12-24 months.
The Later Bucket
Assets in this bucket will be used to fund your upcoming expenses within the next 5 years. These assets could be placed into high-quality government bonds to potentially generate income greater than cash while minimizing the risk you take.
The Much Later Bucket
Assets in this bucket are meant to fund expenses that are 5+ years in the future. This portion of your portfolio will likely be invested in the stock market. Stocks have historically provided returns greater than cash however you are taking on additional risks by investing in them.
Because of these risks, the Bucket approach attempts to ensure there is sufficient cash and fixed income reserves on hand in advance of any turbulent market conditions. This might enable you to avoid selling investments during a down market.
Developing and adhering to a sound investment strategy is essential in retirement. This strategy will likely look different than the one you used during your accumulation years. You must find a balance between today’s spending needs and those of the future if you plan on maintaining your standard of living throughout retirement.
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