Retirement: the word strikes both joy and fear in the hearts of many long-term investors. Joy over the possibilities of post-working life: traveling, pursuing new hobbies and/or spending more time with family and friends. Fear due to all the unknowns: How much should I be saving?; Will I have enough to retire when I want?; What if I run out of money during retirement? The media exacerbates the fear with headlines screaming how unprepared Americans are for their golden years. But retirement investment needn’t intimidate.
Now, ask most financial professionals how to prepare, and you’ll probably get a cliché answer—Save More! But here are four less-often-shared tips to get you started—tips equally applicable if you’re far from retirement or already in it.
Retirement means different things to different people, so the first thing you should do is identify your long-term retirement goals. What do you need your money to accomplish for you? Most investors’ goals will fall into one of three buckets:
Your personal circumstances will determine the degree of growth and/or cash flow appropriate to reach your objectives, but knowing your goals will also define your time horizon—how long your assets need to work for you. This doesn’t end at retirement. Maybe not even your passing! Consider your life expectancy, your spouse’s life expectancy and what you want any leftover funds to do when you and your spouse are gone.
Even if you’re far from retirement, anticipating future expenses will play a big part in calculating your cash flow. Drill down into your finances periodically. I’d recommend to first identify your fixed costs (a fixed-rate mortgage) versus variable (utility bills, etc.). Use averages for variable costs—the longer the period you average, the better. A lot of online banking platforms—including most from the big, tech-savvy banks—can sort and filter to help you.
Next, identify which costs are discretionary. This flexibility can help if you need to make on-the-fly adjustments to spending if an unanticipated bill pops up, or if market results aren’t great. Keeping this written list updated and sharing it with your adviser may be handy. (Particularly after retirement.)
You now know your current state. Next, project what will change in retirement. Granted, this is harder for a 30-year old compared to someone five years from retirement—because so many variables shift—but it’s a guideline, not a perfect projection. The closer you get, the clearer it becomes. When retirement approaches, you will likely have some view of what will be paid off, other income sources you have and your post-retirement expenses. Don’t forget: Expenses change as you age. A 32-year-old’s bills likely differ greatly from an 82-year-old’s.
Cash flow expectations will also impact your portfolio’s ability to meet your personal goals. Armed with your estimate of needed cash flow, divide it by various percentages to come up with a portfolio size capable of generating that cash flow. Exhibit 1 shows a hypothetical example of $80,000 cash flows across four illustrative withdrawal rates ranging from modest to quite high.
Exhibit 1: Reverse-Calculated Principal to Generate $80,000
Then I recommend stress-testing those withdrawal rates using real market results. Monte Carlo simulations or bootstrap Monte Carlo simulations are good tools here. These are mathematical tools developed in thermonuclear physics that combine thousands of investment results across various mixes of stocks and bonds. I took the portfolio values above and ran a bootstrap Monte Carlo simulation. There are 2,500 different combinations results, averaged in Exhibit 2. The results show what should be obvious—lower withdrawals pose less risk you run out of money. But perhaps counterintuitively to some, they also show that adding in stocks can mitigate the risk of depletion!
Exhibit 2: Probability Your Savings Last 20 Years in Various Allocations*
Source: Global Financial Data, Inc. as of 12/31/2013.
That last point is why you should not wed yourself to the myth that the closer you get to retirement, the fewer stocks you should own. Holding more cash and bonds may reduce short-term volatility, but in the long run, it increases the risk of depleting your portfolio. Considering many investors have a long time horizon—perhaps even longer than they believe—maintaining stock exposure may be necessary to reach your goals. There is no holy grail of high-returning, low-risk investments (those are scams). Every asset class and investment has trade-offs, and it is crucial to understand them.
In my view, retirement’s arrival should be celebrated, not feared. By preparing now—no matter what stage of life you’re in—you can make sure your golden years don’t lose their luster. Oh, I almost forgot—and Save More!
* Probability calculated using bootstrap re-sampling, a type of Monte Carlo simulation, a technique which allows for random sampling of historical stock, bond and cash returns while incorporating historical inflation. The simulation takes 2500 iterations of 20-year historical periods and uses them to calculate averages. This statistical method is non-linear and allows for the assignment of probabilities to various outcomes.