As a proponent and practitioner of ongoing financial planning, you will not be surprised to hear me say that the need for retirement planning doesn't end with the onset of retirement. On the contrary, the planning focus simply shifts, from building wealth to preserving and distributing it.
The obvious challenge is to make every effort to ensure that the investment portfolio of recently retired Milestone clients can supply cash flow for the duration of their lives, through a multitude of economic and market conditions and spending needs. Let's call this Portfolio Endurance.
There are three main factors that drive portfolio endurance: asset mix, spending level, and investment time frame. Certain aspects of these factors are within an investor's control, while others are not. Here is a brief consideration of each.
Asset Mix
Asset mix describes the ratio of stocks to bonds within a portfolio. This of course determines ones relative exposure to risk as well as the expected performance of the portfolio, and is one of the most important decisions investors (of any age) can make. Historically, stocks have outperformed bonds and outpaced inflation over time, and this return premium reflects the higher risk of owning stocks.1 Consequently, the larger the equity allocation, the greater a portfolio's expected return, and it's inherent risk.
Keep in mind that risk and return go together. It is the historically higher return potential, or premium, that justifies investing in higher-risk asset classes. Growth can bring higher cash flow, more effective inflation protection, and better portfolio endurance over time. This is why many advisors believe that most investors should have an equity component in their portfolios, with the actual weighting depending on one's time frame, tolerance for volatility, and spending flexibility among other factors.
Spending Level
Portfolio distribution is typically described in terms of either a specified dollar amount (e.g., $50,000 per year), or a percent of annual portfolio value (e.g., 5% of assets each year). Neither method is ideal, and for different reasons:
Specified dollar amount: withdrawing a fixed amount each year and adjusting it for inflation can provide a stable income stream and preserve a consistent living standard over time. But the portfolio may survive as long as you do only if future withdrawals represent a small proportion of the portfolio's value. One academic study quantified this amount, finding that a retiree with at least a 60% stock allocation can withdraw up to 4% of initial portfolio value (adjusted for inflation each year) and enjoy a high probability of never running out of wealth.2 Choosing a higher withdrawal amount than this is not likely to be sustainable, especially if the portfolio faces an extended period of negative returns.
Percent of annual portfolio value: withdrawing a fixed percentage of assets based on annual asset value may make it less likely that you will deplete retirement assets, because a sudden drop in market value would be accompanied by a proportional decline in spending. Therefore, this method can produce wide swings in your living standard when investment returns are volatile, but may be a more sustainable methodology over your lifetime.
Since we all have different living standards and financial goals the key is to weigh these factors according to your individual preferences, either for more predictable cash flow or for increased likelihood of portfolio sustainability. In all cases, the objective from a financial planning standpoint is to customize your withdrawals to maintain living standard, smooth out consumption, and respond to actual investment performance along the way.
Investment Time Frame
Investment time horizon may be the hardest factor to estimate, especially if it corresponds to your lifespan. (If you plan to bequeath assets, your investment time frame may actually extend beyond your lifetime.) How you estimate your individual time horizon will likely influence the level of investment risk you are willing to engage in, and your spending decisions as well. Time frame forces a tradeoff of sorts: retirees with a longer time horizon might choose a higher exposure to equities for the reasons mentioned above, but they may have to offset this risk by being more flexible about spending over time.
Considerations
As you are aware, financial planning involves making reliable assumptions about the future, assumptions which may or may not pan out. Although you cannot avoid making assumptions, you can control how realistic they are and consider how your lifestyle might change if future conditions are different than projected. For instance, even if you are comfortable assuming average historical rates of return, there is no certainty that future portfolio returns will resemble the past, regardless of the time frame involved. Moreover, short-term results may vary drastically; this is why the Milestone financial planning process is focused in terms of probability, not history.
Managing asset mix, payout, and time horizon inevitably involves tradeoffs. The chart below illustrates the dynamics of this. A bond-dominated portfolio with a lower expected return may suit investors with a shorter time horizon, or require them to accept a lower payout rate to increase the odds of portfolio survival. A portfolio with a higher allocation to equities may be appropriate for someone with a long time horizon or a strong desire for a high payout rate, but a higher assumption of risk also results in greater uncertainty about future wealth. Investor flexibility plays a key role in these tradeoffs.
Basic Tradeoffs in Portfolio Survival
Finally, although you cannot fully control the various factors involved in portfolio endurance, having more wealth (through purposeful and disciplined investing, and by taking the fullest advantage of tax-qualified savings plans) can improve the odds of having a less stressful financial life, enabling you to take fewer risks, enjoying a more sustainable spending rate, and potentially extending the productive life of your portfolio.
