Retirement spending plan for low and no risk investors
2nd in a retirement spending series
Every retiree faces the challenge of replacing earned income from employment with income from investments, pensions and social security. The challenge is two-fold: 1. the income must be sufficient to meet the expected or desired spending needs, and 2. the assets must last for their entire lifetime. Neither running out of money in later years nor having insufficient income to live comfortably is desirable. Many academic theories propose the best retirement spending approach, but I believe that individual circumstances preclude the adoption of one theory for every retiree. For example, many variables must be considered including, but not limited to, the following: how much risk a retiree is willing to assume (if any), how much money the retiree has to work with, how much income the retiree needs or how much income the retiree wants if the retiree is willing to take more risk to achieve the lifestyle desired.
The first part of this series discussed the benefits of working with a coach during the pre-retirement years to help avoid the behaviors that may sabotage the best plans. This section outlines the safety-first spending plan for the very conservative investor who naively wants to avoid all risk. In reality, we can minimize but not eliminate all risks. This approach is realistic where the retiree has substantial assets or is willing to receive less income. The third part of the series will discuss a more pragmatic approach, based on the probabilities of future market returns. This approach may suit those willing to take more risk for greater returns.
The “safety-first” retiree is not willing to assume the risk of a diversified investment portfolio in stocks and bonds. They won’t rely on investment averages or past performance. Even though it worked in the past does not mean it will work in the future or it is safe. Unlike the guaranteed income from a bank CD, there is no safe withdrawal rate from an investment account that fluctuates in value. Of course, guaranteed or more stable investments generally have lower returns. We agree that less risk is preferable if the income earned from the assets available is sufficient to fund the retiree’s spending needs. Otherwise, the option is to either defer retirement and accumulate more wealth or retire now and take more risk.
Asset-liability matching: Many people like to separate all their expenses into categories or “buckets” and then pay those expenses from different sources of income. The buckets might include fixed expenses (rent, mortgage, utilities, telephone, food, etc.), variable expenses (restaurants, clothes, gifts, vacations) and a wish list for luxuries, succession or special celebrations. Predictable income sources such as social security and monthly pensions are matched with the fixed expenses while variable income sources such as investment income could be matched with variable expenses. Luxuries on the wish list could be funded with excess savings placed in a bank account.
For the safety-first retiree, the investments used to fund variable expenses might include certificates of deposit (CDs), an immediate income annuity, a laddered portfolio of high quality short and intermediate term bonds that mature every few years and inflation indexed bonds (TIPS). For this type of cautious investor who is uncomfortable with risk or the stock market, lower returns with less risk are desirable. The focus is lifetime spending potential and not maximizing wealth.
Other retirees may be willing to accept some stock investments for longer term luxuries as long as the core expenses are covered with predictable, low risk sources of income.
There are many different types of risk. Many retirees focus on market risk in terms of future events that will interfere with their goal of enjoying a predictable standard of living or force them to lower their spending in the future. They ignore the risk of fluctuating interest rates, inflation and income taxes. For example, current interest rates are at historic lows so higher future rates should be expected and the value of current bonds will decline in value. Of course, bonds held to maturity will return to full value but since inflation often rises with interest rates, the purchasing power at maturity may decline.
Our next retirement spending blog will discuss the value of equity investments for growth and tax advantages to help counter the effects of inflation for those willing to accept market risk.