It’s an investing rule of thumb you probably learned from your grandfather: “Don’t eat your principal!” And Grandpa was no fool. Living off your dividends and assets alone means you aren’t spending down the engine that drives your retirement income. As a result, your principal can continue to work for you for the rest of your life. But while the theory makes sense in some cases, times have changed quite a bit since your grandparents were planning for retirement. And those changes just might mean Grandpa’s guidance is far from the best advice for today.
Consider this scenario: Your retirement is six months away. To prepare, you meet with your financial advisor armed with clear instructions to reallocate your portfolio to tilt towards high-yield, dividend paying, and fixed-income assets. After all, you need to generate income now that your earning years are in the rear-view mirror, so it’s the obvious choice. But is it the best choice for you? Here’s why your grandfather’s trusted rule of thumb may be the very last approach you want to take in 2017:
Bonds may no longer be the wisest option in retirement, but it’s also clear that while equities offer the greatest opportunity for long-term returns, they also present a level of short-term volatility that can introduce greater uncertainty in retirement. So while volatility can be your friend when you are still adding to your nest egg, the game changes when it’s time for retirement and money is coming out of your portfolio at a steady drip. So what’s the solution?
Put these funds in a Short Term Portfolio and begin taking monthly distributions immediately. That’s right. Kick off your retirement right by doing the unthinkable and eating a small piece of your principal! Grandpa may not have approved, but strategically spending down your Short Term Portfolio right away has major advantages in today’s modern-day retirement environment.
The most important advantage of this strategy is that having a two-year “bucket” of assets provides an important safety net, giving your portfolio the ability to withstand any immediate market volatility. Because you won’t be forced to take money out of the Long Term Portfolio for the next 24 months, your portfolio is protected from near-term “sequence of returns risk”—a significant risk to your portfolio that can be posed by even minor negative returns in the first decade of retirement. It can also give you the tremendous psychological benefit of knowing that you’ll have guaranteed income every month for the next two years. And if you’re able to draw those funds from a taxable account, because you’re withdrawing principal, that income is tax-free.
Hypothetically, let’s suppose you know you need $8K each month to fund your retirement, and you’re slated to receive $2K a month from Social Security and $1K a month from your company pension. To provide the remaining $5K each month, you need to take a distribution of $60K each year from your portfolio. Instead of dangerously repositioning your Long Term Portfolio for higher yield and taking all the income, you transfer $120K on Day #1 into a Short Term Portfolio, divided equally between money market funds and (depending on market conditions) short-term bonds. (Note that this Short Term Portfolio is in addition to your Emergency Reserve Account of fully liquid assets to cover 3-6 months of expenses.) From your Short Term Portfolio, you set up automatic monthly distributions of $5K per month.
With your first two years of income covered, you now have the freedom to maintain a more strategic Long Term Portfolio that includes the remainder of your assets. The icing on the cake is that your Long Term Portfolio can be positioned to take advantage of market opportunities—and you can use the annual income from that portfolio to replenish your Short Term Portfolio (a move that may make Grandpa a little more at ease with your approach after all).
Of course, everyone’s needs are different, so discuss this option with your advisor to be sure this strategy makes sense for you. If it is a good fit, you can gain the advantage of 100% guaranteed income for the first two years of retirement—right when the risk to your portfolio is the greatest in the event of a market downturn. What a relief! And because your portfolio hasn’t been relegated to a traditional low-return “retirement” portfolio concentrated in bonds, your portfolio can be positioned for a much higher total return. To top it off, you’ll be saving on taxes, and you’ll have the tactical freedom to adjust your strategy based on the market—not your immediate income needs in retirement.
Heading into retirement at the tail end of a bull market can be scary, especially when you think about the many years ahead. No one can control the market, but by focusing on what you can control, you may be able to truly have your cake and “eat your principal” too. Grandpa would be proud!