Building off of our prior article on "Adjusting Your 60/40 Portfolio For A Zero Yield World" where we discussed doing something different in the new zero interest rate, we want to go through in greater detail how investors should fund their lifestyle from their portfolios. How you withdraw from your portfolios can be as important (or more) than how you invest your portfolios.
The most obvious strategy is pulling from your non-qualified assets first before withdrawing from tax-deferred accounts and subjecting yourself to additional taxes.
One of the most fundamental of all these decisions is your asset allocation breakdown - the percentage you allocate into stocks versus bonds. How much should you allocate to each? Some investors use the "100-age" rule for their equity allocation where you subtract your age from 100% to find the percentage in stocks.
We have written several articles on the topic in recent years and like the rising equity glide path with liability-driven investing ("LDI") overlay. Here, we are reducing the equity allocation as you approach retirement and then start increasing it again around age 75. This is meant to be a sequence of returns mitigate. As the investor ages beyond 75, their time horizon actually starts to increase as the assets can (slowly) start to be considered legacy investments and be evaluated based on the inheritors' life expectancy.
Here, we detail two strategies for calculating that appropriate asset allocation. One uses that liability-driven investing framework, and the other uses a cash reserve.
Calculating Your Ideal Asset Allocation
The plan each investor has for their assets when their age is in the red zone - between 55 and 75 - is critical for their success. And success looks like outliving their assets and building legacy wealth.
During your accumulation phase all the way to age 50, investors should be heavily invested in equities. While the stock market is a roller-coaster, the investor has time to recover from the losses. We think the transition should start to take place around 5-10 years prior to planned retirement.
One 44-year old member recently asked what their asset allocation should be. I said, honestly, if you have 20 years to go, I would be AT LEAST 70%-30% (70% stocks, 30% bonds) and more like 80%-20% to 85% - 15%. And a slice of that bond piece should be in something like closed-end funds to produce higher returns (with greater risks).
For those over the age of 55, the risk is significant. We all know the rise in the longevity as people live longer and longer. Today, someone around the age of 50 that plans on retiring at age 60 could actually have more retirement years than working years. That kind of dynamic can place significant stress on your liquid assets if your withdrawal rate (spending from the portfolio per year divided by total liquid assets to spend from) is above 4.0%.
And we noted that doing the same thing that was done for the last 40 years is unlikely to work for the next 40 years. In order to stave off asset decay (this is where you start cannibalizing and drawing down your assets in retirement), you need to generate a total return that is at least your withdrawal rate plus the inflation expectation. If your withdrawal rate is 4% and inflation expectations are 2% (which is reasonable), you need to produce 6% in order to prevent asset decay.
*Side Note: Asset decay isn't necessarily a bad thing. A planned drawdown of assets is okay so long as you forecast conservatively (i.e. live to age 105, higher spending budget, etc.).
It will be very difficult to hit that 6% bogey even in a 60/40 portfolio. We discussed that recently in our recent report "Adjusting the 60/40 Portfolio For A Zero Yield World."
...going forward, one should expect a high-quality bond fund to produce returns of less than 2% (the Barclays US Aggregate bond Index yield-to-worst is just 1.8%).
In order to forecast equity returns (which are much more difficult), take the starting earnings yield (forward S&P EPS estimate divided by the price, so E/P) and add in the dividend yield. That equates to an earnings yield of approximately 4.1% and the dividend yield is 1.8%. So we can estimate that 5-7 year equity returns will be approximately 5.9%. This is a far cry from the near 12% achieved for most of the last four decades!
So if your bonds get 1.8% and your stocks get 5.9%, then your 60/40 portfolio can be expected to achieve something in the realm of 4.25% per year before any fees.
Even if we increase our estimate to 5%, that is still 1% cannibalization per year before the adjustment for inflation (increasing the withdrawal amount each year for inflation).
This is before sequence of returns risk which we have covered many times before. The math of a big loss early on in your retirement is brutal. Call it bad luck or the luck of the draw, but you don't have any control over the year when you were born which, more than anything else, dictates what year you retire.
The following table shows the ravages of sequence of returns risk. We have Calvin and Hobbes, who both retire at 65, have $1M saved, and plan on taking out 4% adjusted for inflation. And, most importantly, they BOTH achieve a 6% average rate of return.
And the results are dramatically different. You see Calvin ends up at death (age 94) with $1.3M+ to leave to his kids. Hobbes, on the other hand, ran out of money at age 88. Huh? Remember they both had a 6% average annual return.
(Source: Absolute Trust Counsel)
The problem was that Hobbes had some negative years early on, and Calvin positive years. This is why we say the red zone is so important. Asset allocation and security selection are not nearly as important as guarding against this relatively unknown risk. Imagine you did well and outperformed the benchmark by 4%. So, for Hobbes, you were only down 6% in each of the first two years. In the end, you still run out of money at age 91. So, performance matters, but not nearly as much as mitigating this risk.
So, what do you do?
There are two strategies we endorse (among the many), one more favorable than the other. For those in the red zone, the strategies you can take are:
- Liability-driven investing
- Cash reserve
Liability-Driven Investing (LDI) | Matching Income To Spending
Liability-driven investing is something we've touched on many times over the years on our marketplace service. It essentially says you produce an overall yield on your assets so that the income produced is enough to satisfy your income need from the portfolio.
For example, if you live on $100,000 per year, and you get $30,000 from Social Security, then you need $70,000 from your portfolio. If your portfolio is $2,000,000 in aggregate, then your withdrawal rate is 3.5%.
The liability-driven investing framework says that you invest a large portion of your investments in income-producing securities to make sure you generate an after-tax income of $70K. The remaining assets can then be invested as you see fit - in more income or in equities for long-term growth compounding. It allows for a lot of flexibility. But what it also does is to allow you to be fully invested and ride the waves knowing you don't ever have to sell down. This is very important.
Selling down is what imperils portfolios. The largest retirement mistakes are made when you are forced to sell something rather than wanting to sell something.
We've used this chart many times showing that an investor needs to be able to weather the volatility knowing they are getting paid. The chart below details PIMCO Corporate & Income Opportunity Fund (PTY), a closed-end fund. Over the years since it came to market in 2003, the share price has risen from $15 to $18, then fell to $6, rebounded to $22, fallen back to $11.80, and risen back to $20.
What's important is that the investor scenario in the chart above never sells. Instead, they collect their income almost like a pension or income annuity. The numbers on the bottom in blue detail the income collected, assuming an extreme example of placing $1M in PTY at the IPO. Total income collected through February was $2.16M. But notice the share price is essentially unchanged from the IPO price nearly 17 years earlier. But the annual return was over 13.8%! That bests the S&P 500!
Now, this is an extreme example. By diversifying across many CEFs, ETFs, and mutual funds as well as individual securities, we mitigate a lot of that volatility to make is 'acceptable' to us to weather.
So, that's strategy one. Place your assets into a mixture of income securities with the Core Portfolio at the center accounting for 20%-30% of the portfolio and match income to spending. This is not dissimilar to what you did all your working lives. A bill or liability came up, and you paid it out of cash flows from your employment.
During retirement, that mentality does not change. The difference is you no longer have your employment. Instead, we pay out of the "work" our hard-earned savings are doing producing that income for us. But the investor needs to HOLD! and not let emotions get the best of them.
Strategy Two | Cash Reserve and Time-Weighted Asset Allocation
This is a much more common strategy by financial advisors today. Essentially, the investor places about 2-3 years' worth of portfolio spending into a cash reserve (pure cash). The theory is that, in a bear market, you can cease drawing on your investment assets and live off the cash until the market recovers. Most bear markets last around 18 months and recover in 3-4 years. So, having a few years' worth of cash will mitigate a lot, if not all, of that sequence risk.
This strategy is slightly lower risk as it has a cash buffer. It also doesn't rely as much on income production. Most of the strategy rests on making sure your withdrawal rate (not including the cash reserve) is low enough for the portfolio to last. Even if your portfolio achieves a total return that is less than the withdrawal rate plus inflation, you should be able to make that portfolio last a long time by utilizing that cash reserve.
The cash reserve also allows a greater allocation to equities (should your risk tolerance allow it), given the cash buffer.
In prior articles, we've discussed using cash value life insurance as a cash reserve as it would provide a decent rate of return that is tax-deferred. However, most people would need to start earlier in life and cannot just wait until retirement to plan for that. We recommend starting an overfunded life insurance policy before the age of 45 with a good mutual insurer.
The following diagram is a way to think about it and calculate a true asset allocation.
- The income analysis section on the upper-left calculates how much money the retirees would need to draw from the portfolio. You can see in this example that they want $12,500 per month. After Social Security for both spouses, a positive cash flowing rental property, and a small annuity, they need about $5,075 per month from the portfolio.
- That is a 3.0% withdrawal rate from their $2,000,000 asset base.
- In the current assets section, it calculates a cash reserve based on 2.5 years of spending [5,075*12*2.5 = 152,250].
- The replenishment of the reserve can occur from income from the fixed income investments and/or opportunistic selling. Some advisors do annual or semi-annual asset sales based on what was up during the trailing period. If large-cap US was up, they would trim that to refill that bucket.
Our Yield Hunting marketplace service is currently offering, for a limited time only, free trials and 20% off the introductory rate.
Our member community is fairly unique focused primarily on constructing portfolios geared towards income. The Core Income Portfolio currently yields over 8% comprised of closed-end funds. If you are interested in learning about closed-end funds and want guidance on generating income, check out our service today. We also have expert guidance on individual preferred stocks, ETFs, and mutual funds.
Check out our Five-Star member reviews.
Click here to learn more.
