Let’s suppose you have a clear estimate of how much money you will need after you retire and how much of that will need to be generated by your investments. Let’s also assume that you have a good sense of your investment time horizon—how long you need your portfolio to work for you, your spouse or for the next generation, depending on your goals. At this point, you can begin thinking about how you will meet your retirement needs.
For many retirees, investments in retirement accounts such as 401(k) plans, IRAs and Roth IRAs make up a significant part of their retirement savings. In addition to other forms of non-investment income, such as Social Security and pensions, many people will rely on investments to help cover costs or expenses to maintain their lifestyle after they retire. One key to making this work is to ensure you are generating enough money to last given your investment time horizon.
You’ve worked hard and deserve the comfortable retirement you have always envisioned for yourself. Before considering strategies you can use to draw on your investments post-retirement, let’s take a closer look at how to calculate your expenses in retirement.
When calculating your costs in retirement, consider your expenses in relation to non-discretionary spending, discretionary spending, inflation and investment time horizon:
You may generate some of your retirement income from a salary (if you plan on working during retirement), pension, Social Security benefits or business and real estate income. But chances are you will need cash flow from your investment portfolio to fully cover your retirement expenses. Fortunately, you have many options for achieving this.
While planning for your retirement don’t focus too narrowly or literally on income at the expense of cash flow. The distinction between income and cash flow is important.
Income is money received. In a retirement portfolio, income typically comes in the form of interest and dividends.
Cash flow, in contrast, is money withdrawn. In a retirement portfolio, cash flow can include money from income sources, but it can also include money withdrawn from selling assets such as securities.
A common and seemingly appealing strategy is to select investments that can provide regular income at minimal risk. This approach can lead to heavy investments in bonds and dividend-bearing stocks.
This strategy can deliver predictable income, but it also comes with risks:
Exhibit 1: 5-Year Rolling Periods
Exhibit 2: 30-Year Rolling Periods
*Standard deviation represents the degree of fluctuations in the historical returns. The risk measure is applied to 5- and 30-year rolling annualized returns in the above charts.
Source: Global Financial Data, as of 11/06/2018. Average rate of return from 12/31/1925 through 10/31/2018. Rolling stock return based on Global Financial Data’s S&P 500 Total Return Index. The S&P 500 Index is a capitalization-weighted, unmanaged index that measures 500 widely held US common stocks of leading companies in leading industries, representative of the broad US equity market. Rolling Fixed Income return based on Global Financial Data’s USA 10-year Government Bond Index.
Organizing your portfolio around the goal of receiving income can significantly harm your ability to withdraw funds without running out of money.
In contrast, shifting your investment focus from income to cash flow can help you maintain a portfolio with the assets that give you the best chance of meeting your goals. It can also help meet portfolio growth needs, since stocks have historically generated higher average returns than fixed-income assets. Portfolio growth is critical for many investors; it increases your capacity to cover your retirement expenses, and helps you keep pace with inflation or stay ahead of it.
By selling stocks to generate cash flow you are receiving what we call “homegrown dividends.” This presents you with a couple of advantages:
If you plan on taking regular distributions—that is, an annual withdrawal amount divided into fixed monthly disbursals—then you might consider keeping some cash in your portfolio. That way you aren’t forced to sell stocks at inopportune times. But remember, holding too much cash could mean foregoing the growth you can get from holding assets.
Last but not least, this strategy can present tax advantages in taxable accounts.[ii] Security sales are taxed as long-term capital gains (if held for at least a year), and are generally lower than taxes on bond interest and dividends, which will likely be taxed as income at your marginal income tax rate.
Understanding your cash flow needs and planning to meet those needs in retirement can be daunting. Fisher Investments can help you assess your retirement needs, create a personalized portfolio to meet those needs and manage your investments to generate cash flow for your retirement.
[i] Source: Factset, as of 2/12/2018. Based on US BLS Consumer Price Index from 12/31/1925 to 12/31/2017, average annualized inflation was 2.91%.
[ii] The contents of this document should not be construed as tax advice. Please contact your tax professional.