One of the most important decisions investors face is the asset allocation of their portfolio. For the retiree it will be inextricably tied to a second critical decision: the spending strategy used during retirement.
This is simply the percentage of a portfolio invested in the various asset classes such as stocks, bonds, and cash. It should be the top priority in constructing and managing a portfolio because it determines almost all of the risk and performance an investor experiences, and greatly affects the chances of meeting goals. Since we can’t predict the future and don’t know which asset classes will perform best, we can’t know in advance what that optimal allocation will be. We can however, apply sensible investing principles and build a portfolio that is broadly diversified, tax-efficient and consistent with goals and investing temperament.
As retirement approaches investors often shift more of their assets toward income producing investments such as bonds, and away from more volatile ones like stocks. This is generally a sound practice for retirees who rely on investment income (rather than working income) and have less time to recover from market declines. However, retirees often take this concept too far and fail to balance the need for both current income and long-term growth, thereby running the risk of depleting their portfolios prematurely.
Investors typically employ one of two spending approaches during retirement; the income method or the total return method.
Using the income method, investors spend only the income (interest, dividends, and capital gains) generated by the portfolio. However, unless they have substantial assets or very low spending needs, they will need to increase the allocation to bonds and/or dividend paying stocks. Unfortunately, this is not an effective strategy for maintaining the retiree’s inflation-adjusted spending or capital appreciation of the portfolio. This approach can initially generate a fairly high income, but at the expense of the after-inflation purchasing power and the after-inflation value of the portfolio itself, both of which will erode over time. This increases the likelihood that the portfolio will be depleted prematurely. Also, because the income approach ignores the important asset allocation decision, and lacks the diversification provided by other available asset classes, it unnecessarily increases the portfolio’s risk.
The preferred alternative to spending income only is a total return spending approach where the income (interest, dividends, and capital gains) is used first. If this proves insufficient to meet spending needs, the investor then taps some of the principal. This means, in situations when the total portfolio cash flow is more than the retiree needs, the total return approach is equivalent to the income approach. With the total return method the investor does not base decisions on maximizing income. The focus is on establishing and maintaining the appropriate asset allocation, portfolio diversification, and balancing the need for current income with long-term portfolio growth. This helps decrease the portfolio’s risk and increase its longevity.
Much of the research conducted comparing the income and total return approaches suggest that unless the retiree’s portfolio is substantial relative to their spending needs, the total return approach is more effective in reducing the likelihood they will run out of money.
The bottom line: the portfolio should be determined by sensible asset allocation and the need for balancing current income with long-term growth.
This article is for general information purposes only and is not intended to provide specific advice on individual financial, tax, or legal matters. Please consult the appropriate professional concerning your specific situation before making any decisions.