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Portfolio Changes in Retirement


Jack Piazza
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 asset 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 asset depletion. Let's review these factors.

 Amount of Income Needed 

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, pensions and 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.

Special Note: 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 lower 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.



After 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.

 Sufficient Growth in Portfolio 

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 much 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.

 Portfolio Earning 4% per Year  

Annual   Withdrawal Rates

 5%   6%   7%  8% 9% 10%

 Number of Years until Full Depletion  

 34.0   27.0   20.9   17.2   14.6   12.7 


 Portfolio Earning 6% per Year  

      Annual     Withdrawal Rates

 7%   8%  9% 10% 11% 12%
 Number of Years until Full Depletion    30.5   22.4   17.8   15.0   12.9   11.4 


 Portfolio Earning 8% per Year  

      Annual     Withdrawal Rates

 9%   10%  11% 12% 13% 14%
 Number of Years until Full Depletion    24.9   19.0   15.6   13.2   11.7   10.3 

    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 assets.

    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 very clear.

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.

With 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.

Finally, 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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