Ready to Retire? How to Ensure You'll Have the Income You Need

You have worked your entire life for the big payoff: financial independence. Most of us think of it as just plain old retirement. It happens the day you can decide what you want to do, not what you have to do. To reach that point you must determine that there will be enough money coming in to meet your cash flow needs.

How much is enough? You'll realize rather quickly that nothing is static -- nothing is really "fixed" when you reach retirement. The bigger question (and it's a doozy based on your Email) is whether your retirement planning is flexible enough to respond to your changing lifestyle and the changing economy.

Today I want to discuss one narrow but important aspect of retirement: income needed from your portfolio. To take money randomly from a portfolio will not work over a long period of time. You need a strategy. But before creating
an income strategy, you must define what your income
needs are.

Once you have figured out how much total income you will need, the next step is to credit Social Security, pension, lottery payments and any other steady sources of income against your needs. The difference, if any, will need to come from your investment portfolio.

Let's take an example:

Figuring Your Needs from Investments Annual Income Needed 40,000 Social Security -12,000 Pension -15,000 Net Remaining Need 13,000

You need $13,000 a year from your investment portfolio. Let's say you have investments of $250,000. Seems simple enough. Just take about 5.5% a year from the portfolio and you will have $13,750. But what if the $250,000 drops to $130,000?

At 5.5%, you get $7,150 -- almost $6,000 short of your needs. Chances are the market by then would have scared you enough so you might not get back in for a long time. Then you would gradually eat up principal and eventually have to eliminate the annual trip to visit the grandkids.

Wondering where I came up with the drop from $250,000 to $130,000? That is the amount the S&P 500 dropped over two years from 1973 to 1974 -- 48%. So, what's a person to do? Let's build another strategy that should work better.

Our goal is to maintain our cash flow, hedged for inflation in down markets. Here are some assumptions you need to consider:

Inflation

Inflation will affect your buying power. If you're age 60, inflation has averaged 4.1% per year for your lifetime. So, if you're 60 now and need $40,000 this year, then to have that same buying power at age 78 you will need $80,000 overall, thanks to the inflation rate. And $26,000 of that $80,000 would come from your investments.

Each year we need to adjust for inflation to protect buying power. Also, we need to keep a significant percentage of our money in stocks or stock funds to have growth in excess of inflation.

Withstanding Down Markets

Since 1953, there have been 14 markets that have had an average decline of 24%, lasting an average of eight months and taking an average of 13 months to reach the 100% recovery level. For our planning purposes, we will assume a three-year period from loss to recovery in the market. If you want to be even more cautious, use four to five years.

We need to put enough money in short-term fixed-income investments to cover our assumed three-year cycle from loss to recovery.

Worst-Case Scenarios

We assume that catastrophes such as accidents, health problems, et cetera, are covered by appropriate amounts of insurance.

Keeping all that in mind, consider the following strategy:

Put one year's worth of income ($13,000) into a money market fund. Use this to live on for a year.

Put at least two years of income ($26,000) into a short-term bond fund, which should not fluctuate much at all, even in a down market.

Put the balance into a well-diversified stock portfolio that could include balanced funds (stocks and bonds). While the short-term bond fund gives you your core protection, that doesn't mean the rest of your money needs to be in stocks. Some certainly should, but you can inject bonds into that mix as well.

At the beginning of each year replenish the money market fund with money from the short-term bond fund, and replenish that -- if you can -- with money from the stock and bond portfolio. Adjust for inflation using last year's CPI. In other words, simply transfer money from the investment portfolio to the bond funds. About 15.6% of the overall portfolio is in a low-risk fixed-income position (the money market plus the short-term bond fund). This strategy will assure you of an income for three years regardless of the behavior of the market.

In my example here is the way it would look:

Components % of Portfolio Value Money Market Fund (1 year) 5.2% $13,000 Short-Term Bond Fund (2 year) 10.4% + $26,000 Stock & Bond Portfolio 84.4% + $211,000 Total 100% $250,000

If the market goes down in any year, do not take any money out of the stock and bond portfolio to replenish the bond fund. You need to give the stock and bond portfolio time to recover. In the meantime, you have created a three-year firewall against a down market.

The allocation of the $211,000 in the investment portfolio is important. Theoretically, we only need to increase it by the amount of inflation. We can afford to be very conservative. We do not need to hit home runs, just consistent singles and an occasional double.

This game plan does not call for trying to match a hot bull market. For example, the S&P 500 averaged 30% for 1995, 1996, and 1997. We may have "only" averaged 10% to 12%. That more than meets our objective, so we should feel good about it -- we "underperformed" the common benchmark because we took much less risk.

Most people have forgotten that in the three years previous -- 1992, 1993 and 1994 -- the S&P 500 only averaged 6.27% a year. While there are obviously no guarantees, the same portfolio that "underperformed" the hot market probably beat the market's rather mediocre performance from 1992 to 1994.

The portfolio allocation for the stock and bond fund that could perform as described above would have about 50% defense and 50% offense. (See my earlier columns on offensive and defensive portions of the portfolio.) The defense would consist mostly of balanced funds that invest in stocks, bonds, and cash. The offense would consist mostly of the more conservative growth and income funds.

In summary, I have tried to build a safety net under both your income and your investment portfolio. The goal is to meet your needs and not the S&P 500 benchmark. There are a lot of variations to this strategy -- my main purpose was to give you the idea so you could tailor it to your needs.