How much can I spend during my retirement? How do I manage risk in my portfolio in order to meet my goals? These are tricky questions with a lot of variables. To answer these questions, it may be helpful to talk with a professional who can guide you in the right direction. But for starters, the most important factors to consider are retirement age, proper portfolio diversification, and inflation. Let’s take a look at all three.
Did you know that if you and your spouse are 65 today, the probability that one of you will live to 85 is 74% and the probability that one of you will live to 90 is 47%? If you are a single man or woman age 65, the probability that you live to 85 is 42% (man) and 54% (woman) and the probability that you live to 90 is 22% (man) and 33% (woman). (Statistics from slide 6 of JP Morgan's Guide to Retirement)
So, for purposes of figuring out time horizon, your financial advisor should be running projections to at least age 95. What this means is that at age 65 you need to have your portfolio properly diversified to last at least 30 years. Therefore, the important thing to remember is that putting your money in CDs at today's rates and hoping you won’t outlive your assets is not a viable option in 2016!
Properly Diversifying Your Portfolio
So if CDs aren’t the answer, how should you diversify your portfolio? Let’s assume that you are 65 and going from an accumulation phase to distribution phase… Should the majority of your assets be in bonds or cash alternatives…? Well it depends, but for the average retiree, NO!! Remember, we have to assume you will need to withdrawal off your portfolio for at least 30 years! That is a long time horizon, and don’t forget interest rates are at historic lows. So, using a mix of equities and bonds will be essential to the longevity of your portfolio.
Your portfolio should be designed based on your risk tolerance, however you also have to consider your risk dependence or how much risk do you need to take on to meet your goals. For example, if you have $1,000,000 dollars in your portfolio and need to withdraw $50,000 per year, you will have to take on more risk than someone who has a $1,000,000 and only needs to withdraw $20,000 per year. Makes sense right? That being said, risk dependence is not the only type of risk you need to consider. You also need to consider purchasing power risk because your purchasing power will most likely decrease year-over-year due to inflation.
Inflation affects the purchasing power of your money. What that means is that you will need more money this year to buy the same products than you did the last year. So, if you are using CDs, money markets, or other cash alternatives to produce income during your retirement, you will most likely be losing money as the yields being produced from these investments are subpar to the inflation rate.
Did you know that one of the best ways to combat inflation is to invest in equities? It’s true! Taking on risk in equities should greatly reduce the effect of inflation. There is a great chart by BlackRock that explains this more:
So what’s the point here? The point is there is no one magic number that is the proper withdrawal rate. However, if you need your money to last for 30 years, it is probably a fair bet that you will need anywhere between 60% and 40% in equities and that you should not be withdrawing more than 4% per year from your portfolio.
Working with a financial advisor to make sure you are properly invested can have a significant impact on your ability to spend what you want during retirement. And, if you are weary of equities, just remember that over a rolling 5 year time horizon since 1950, a fifty percent mix between the S&P 500 and Barclay's Bond Aggregate Index has not lost a hypothetical investor money*. (Don’t believe me? Check out slide 64 of JP Morgan’s Guide to the Markets.)
Cody Reading is a financial advisor at MSMF Wealth Management. He specializes in retirement planning strategies and believes that the best part of his job is helping clients reach their financial objectives. In his spare time, Cody enjoys hiking, cooking, traveling, spending time with his family, and attending Cardinals and Blues games.
*Source: Barclays, FactSet, Federal Reserve, Robert Shiller, Strategas/Ibbotson. J.P. Morgan Asset Management. Returns shown are based on calendar year returns from 1950 to 2015. Stocks represent the S&P 500 Shiller Composite and Bonds represent Strategas/Ibboston for periods from 1950 to 2010 and Barclays Aggregate thereafter. Growth of $100,000 is based on annual average total returns from 1950-2015. U.S. data are as of November 30, 2016. All investing involves risk, including the possible loss of principal. There is no assurance that any investment strategy will be successful. Investors cannot invest directly in an index. Past performance is not an indication or guarantee of future results.