Portfolio Changes in Retirement
Sensible Investment Strategies
Retirement....the ultimate goal. For most people, retirement not only brings a change in lifestyle, it
also necessitates a major change in their mutual fund portfolio. In retirement, the vast majority of investors must switch gears from
accumulation to asset withdrawal -- this fundamental change requires
(1) an assessment
of income needed for a desired lifestyle and (2) a re-evaluation
of portfolio return objectives and risk tolerance.
Ideally, an effective retirement strategy should provide adequate income to last over an individual's
remaining life span, cash for emergencies and sufficient growth to protect assets against
asset erosion. The three major challenges facing retirees: (1) creating an appropriate
allocation strategy that addresses realistic withdrawal rates
for income, (2) estimating the amount of money needed for emergencies and (3)
including sufficient growth in the portfolio to protect against rapid portfolio
Let's review these factors.
Amount of Income
First estimate annual living expenses for retirement. Then
figure how much pre-tax income is needed in
retirement. One general rule has been to estimate retirement
expenses at 70-80% of pre-retirement
income, but many individuals pick up additional expenses in retirement such as
increased travel, club memberships, etc. To be precise, it is best to itemize current
expenses, then add or subtract for expense adjustments as needed.
To calculate a pre-tax
number, divide retirement expenses by one minus your tax bracket. Once you have the pre-tax income estimate, figure the income that would be needed from
your mutual fund portfolio, after subtracting distributions from social security,
any other sources of income (individual stocks, limited partnerships, etc). Reminder: withdrawals from tax-deferred accounts (401K, traditional IRA, etc.) are
treated as taxable income.
High income earners should consider the ramifications of future tax rates. For example, Health Care legislation became
law in early 2010 which imposes a 3.8% Medicare surtax on income exceeding
$200,000 for individuals, or $250,000 for joint filers -- beginning in 2013.
This surtax will be assessed on the
of (1) Net Investment Income, or (2) Modified Adjusted Gross Income (MAGI)
in excess of the income thresholds for single or joint filers.
Net investment income
for the purposes of calculating the unearned income Medicare
contribution tax includes interest, dividends, capital gains,
annuities, royalties, rents, and pass-through income from passive
businesses. The following types
of income will not be subject to this additional Medicare tax:
tax-exempt municipal bond interest, nontaxable veteran's benefits,
capital gains excluded from the sale of a principal residence, and
distributions from traditional and Roth IRAs, 403(b) plans, 401(k) plans, 457 plans,
pensions and profit-sharing plans.
- Case A: a single flier
or a couple filing jointly exceeds MAGI thresholds with zero
net investment income. No Medicare surtax is due (zero net investment
income x 3.8% = zero).
- Case B: a single flier
or a couple filing jointly is under MAGI thresholds with $100,000
net investment income. No Medicare surtax is due since excess MAGI
thresholds did not occur.
- Case C: a single flier
or a couple filing jointly exceeds MAGI thresholds by $40,000, of
which $50,000 is net investment income. The 3.8% Medicare surtax of $1,520
would apply to the $40,000 excess MAGI since it is lower than the $50,000
net investment income.
- Case D: a single flier
or a couple filing jointly exceeds MAGI thresholds by $40,000, of
which $30,000 is net investment income. The 3.8% Medicare surtax of $1,140
would apply to the $30,000 net investment income since is is lower than
the $40,000 excess MAGI.
figuring annual pre-tax income, determine the amount of money needed for
emergencies. In pre-retirement, the standard rule of thumb was to keep three to six
months of living expenses in a money market fund (or equivalent); the reasoning for
this is to assure that long-term growth-oriented strategies could continue uninterrupted.
However, to account for
unexpected expenses (medical costs, home repair, etc) or market downturns in
retirement, you may want to allocate up to twelve months of living expenses in a money market fund, an ultra short-term bond
fund and/or a short-term treasury bond fund. Note: many retirees may have
adequate emergency funds which would cover six months of living
expenses -- the actual number of months covered in an emergency fund will vary due to an investors
"comfort level" and individual circumstances.
Some advisers recommend
allocating up to10% of assets for this purpose in a long-term, income-oriented
portfolio -- however, if your time horizon is less than five years, then you may
feel more comfortable with a larger percentage (e.g., 15-20%) in a combination of a money market fund and a short-term
government bond fund for emergencies. However, the size of your portfolio,
along with up to twelve months of estimated expenses, should be the determining
factor rather than a percentage guideline.
Once pre-tax income and emergencies
amounts have been determined, the next step is to address what role growth has
in your retirement portfolio. Exactly how much allocation in growth depends upon the asset size of your
portfolio and amount of income needed. Depending upon the size of assets, the purpose of
growth in a retirement portfolio may be several fold:
Protection against inflation erosion of assets.
Assuming a historical 3% inflation rate, an income of $40,000 today would need an
income of approximately $72,250 in twenty years to retain current purchasing
power. Unless your portfolio had sufficient growth to offset this
effect of inflation, you would be forced to either (1) withdraw assets at a
higher rate than portfolio earnings, which would shorten portfolio life -- e.g., withdrawing
10% when the portfolio
earns 8% or (2) significantly lower your standard of living -- which would
be undesirable for most retirees.
Protection against a depleting portfolio. If
withdrawal rates exceed portfolio earning rates, portfolio life is
shortened. Excluding the effect of inflation and taxes, if you withdraw 10% a year from a portfolio earning
6% annually, your assets will be fully depleted in 15 years; in the above example where annual withdrawal is
12% verses 6% annual earnings, the portfolio would be fully depleted in just
11.4 years. When withdrawal rates are greater than earning rates, sufficient
portfolio growth is needed to help extend assets over life expectancy.
The following tables illustrate various withdrawal rates and the number of
years a portfolio would last. Note: these examples exclude the
effect of taxes and inflation, both of which would significantly shorten the
portfolio life in these examples.
Earning 4% per Year
Annual Withdrawal Rates
Number of Years until Full
Earning 6% per Year
| Number of Years until Full
Portfolio Earning 8% per
| Number of Years until Full
Protection for increased life expectancy. Due to
advances in medicine and increased awareness in nutrition, the life
expectancy for both men and women is increasing. Adequate
portfolio growth is necessary to assure that you do not "out live" your
Portfolio growth for estate. If one of
your objectives is to pass assets to your heirs, then a portion of your portfolio should be
in stock funds. Like the rest of your portfolio, the stock funds should
reflect your level of risk tolerance and be well-diversified.
All of these factors are essential in shaping
a portfolio strategy. For many investors in retirement, the appropriate
strategy emphasizes income and stability over growth or balanced-oriented return
objectives. Others may find a balanced-oriented asset allocation or a modified
growth-oriented allocation to be more appropriate for their needs and
objectives. The amount of income needed and the asset size of the
mutual fund portfolio are the key factors in selecting a growth, balanced or
income-oriented objective. The important step is to first allocate for income needs
and emergencies....then the remaining portfolio allocation for growth is usually
In an ideal portfolio situation, income needs would be generated from bond fund
yields, adequate emergency reserves would be in money market and/or
short-term bond funds with the remaining allocation of portfolio assets in equity funds for growth. Yet, many retirees at some point will use distributions or capital appreciation in stock funds (the growth allocation) to supplement income
and/or to counter the effects of inflation. This is very
acceptable -- just remember that stock fund dividends are paid semi-annually and
capital gain distributions (when they occur) are usually distributed annually,
so budget accordingly.
any growth, balanced or
income-oriented objective, levels of risk tolerance can be either aggressive,
moderate or conservative. The degree of volatility that a retiree finds
comfortable should be the determining factor in selecting a risk
tolerance level. Retirees often have a lower level of risk tolerance than when they
were accumulating assets -- sometimes portfolio risk tolerance remains the
same, but it rarely increases in retirement. Regardless of return objectives and risk tolerance,
a portfolio should provide effective
diversification by spreading assets among different and distinct fund
categories to achieve not only a variety of distinct risk/reward objectives, but
also a reduction in overall portfolio risk.
monitor your expenses and portfolio at least annually. Also look for any major changes in your spending
or in your asset mix. Assuming your objectives and risk tolerance
have not changed, rebalance your portfolio to the original allocation mix if
your income needs have not significantly changed. However, if your income needs
have significantly changed, then you should reassess your plan, starting with
the amount of income needed, emergencies reserves and then sufficient growth.
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