Two weeks ago, I proposed an extremely simple calculation to determine if you have enough for retirement. Simply take your retirement nest egg and divide it by the number of years you’ll be in retirement.
For example, $3,000,000 in your portfolio, divided by 40 years of retirement, means you can take $75,000 per year from the portfolio. If the portfolio is all cash, you’ll have no investment risk and will hit year 40 with exactly zero dollars left. Perfect!
Except… $75,000 in 40 years is only the equivalent of a $23,000 income if inflation is 3%. That’s a major hit to your lifestyle over time. So, can we keep this perfectly simple calculation and remove the risk of inflation?
The answer is yes! By simply investing the portfolio into a bond ladder with a net yield that equals inflation, your withdrawal can increase each year, from $75,000 in year one to $238,000 in year 40 (I’m using a 3% inflation rate). Every year, a bond will mature in the portfolio in exactly the amount you planned to take for income. If you’re using CDs and/or Treasuries, the only risk you’ll bear is government default or negative real yields — which can and does happen. But the retirement math remains the same — your portfolio divided by the number of years in retirement.
Just make sure you won’t outlive the number of years used for the equation! There will again be zero dollars left at the end.
Here’s the problem. Most of us aren’t comfortable with a retirement plan that 1) is guaranteed to fail if the government defaults or real yields are negative, and 2) leaves nothing for our family at the end.
Here’s the solution. We use 1/4 to 1/2 of the portfolio (depending on how long your retirement is) to invest in a diversified bond ladder which locks in the next 10 years of needed income and isn’t solely dependent on government solvency. Then, the remainder of the portfolio is invested in a diversified mix of assets that guards against inflation risk, interest rate risk, market risk, credit risk, and currency risk. This portion of the portfolio will have a variable return — some years positive, some years negative — just like any fully diversified investment portfolio.
Each year of your retirement, a bond matures providing exactly the amount of income you need to withdraw, and a decision is made to either extend the bond ladder another year or wait to extend the ladder. To make this decision, we set a target portfolio value that we know will last throughout retirement. In years where the investment portfolio is increasing relative to the target value, the bond ladder is extended. If the investment portfolio is decreasing relative to the target value, we wait, knowing that the remaining bond ladder will continue to provide the needed income each year until it is replenished.
Here is how this process works over a 40-year retirement with a sample set of investment returns*:
The slowly increasing green line is your $75,000 annual income need rising with inflation (amounts shown on the left side of the graph). The blue bars are the 10-year bond ladder, exactly matching the needed income, and the gray bars are future additions to the bond ladder as investment returns permit. It is important to note that the income goal does not have to be steady like this example — we can add extra cash flows for travel, vehicle replacements, and other anticipated income needs.
The total portfolio value is shown on the right side of the graph. The blue dashed line is the target value over time. In this case, the client wants to leave $1,000,000 to their children at the end. The solid orange line is the total portfolio investment value as it varies over time due to income withdrawals and market returns. (*The sample shown is a randomized return series with a 3% bond ladder yield, and a 5.5% investment portfolio return with a standard deviation of 8%.)
Whenever the orange line is increasing relative to the target value (dashed line), the bond ladder is extended by one or more years. I have circled a few examples of when the ladder would be replenished, and when it would not.
The beauty of this approach to retirement income planning is that the following things become possible:
1) We can rely on an incredibly simple way to calculate retirement income from a portfolio — total portfolio value, divided by the number of years. The investment approach takes care of the inflation factor, and the size of the bond ladder will be determined by your time-frame, risk profile, and the amount you desire to have left for family.
2) Superior behavioral outcomes. The most devastating thing you can do is to abandon a sound investment strategy during a period of declining returns. By having 10 years or more of income secured in a bond ladder, retirees are at far greater ease with the routine fluctuations in the value of the investment portfolio, making it easier to adhere to the strategy and succeed long-term.
3) Just like our approach to strategically rebalancing client portfolios, funding the bond ladder only when returns are positive significantly increases the success rate of the financial plan for the client.
4) The ending wealth derived from this approach often exceeds the target, allowing for greater discretionary spending during retirement, family gifts, and the ability to remain financially independent beyond your life expectancy.
Financially speaking, it’s the perfect retirement.
We have been implementing this process with our retired clients for over 15 years using a number of approaches — establishing a “defensive reserve” for income, strategic rebalancing of a unified portfolio, and setting up income-specific bond ladders as described above. The exact approach is unique to each client, based on the structure of your assets, the availability of other income sources, your risk profile, and many other factors. And taking care of the income funding each year simply must be done specifically for each client — assessing asset returns, looking at future income needs, and making the necessary portfolio adjustments and trades.
You just need to know your total portfolio value and the number of years you’ll be in retirement — we’ll take care of the rest.
Have a great weekend!