There are two retirement income planning rules that should always be kept in mind: 1. do not run out of money; and 2. do not forget the first rule.
It’s true that this seems basic, but it can get complicated. It’s tricky to negotiate between two very important concerns: the need for growth to mitigate inflation over the life of a retiree, and the need for safety and capital protection. Very few people have a desire to take great risks when it comes to their hard-earned retirement funds. With that in mind, a zero-risk investment portfolio will still slowly erode your nest egg’s value.
As hard as it is to believe, zero-risk portfolios will most likely fail to achieve any reasonable economic goals you might have. However, an equity-only portfolio can come with volatility that risks elimination if withdrawals continue to happen during down markets. Because of that, we believe the best strategy balances these two requirements.
Your goal is to create a portfolio that balances the requirements of liberal income with adequate liquidity. You can start by dividing your portfolio into two parts with different, but specific goals for each:
Each portion of your portfolio should contribute to the main goal of creating a liberal and sustainable withdrawal over long periods of time. Keep in mind that you are specifically not investing for income — you are investing for total return.
The importance of tax preparation is simple: it may help save money and prevents you from overpaying your taxes.
Let’s think back to our grandparents. How did they invest? They invested for income and packed their portfolios with dividend stocks, convertible bonds and more generic bonds. The motto then was to live off the income and don’t touch the principal. They chose individual securities solely based on great yields. What was the result? They ended up with a portfolio that had lower returns and higher risk than needed.
To be fair, dividends and interest were much better back in their day. Even though their strategy was not close to being perfect, it did work to some degree.
We have a better way to think about investing today. The main motivation of modern financial theory is to adjust the focus from individual securities selection to asset allocation and portfolio creation, and to focus more on total return rather than on income. If for some reason your portfolio needs to make distributions, it is possible to choose among the asset classes to shave off shares as needed.
If you’re ready to start enjoying the rewards, you need first learn a few fundamental tax planning tactics. These will
Total return investing creates portfolio solutions that are designed to offer much more optimization than the previous income-generation methods. Distributions are funded efficiently from any portion of the portfolio without regard to accounting income, interest or losses.
Varying laws and regulations have changed over the years to incorporate the idea that investing for income is not an appropriate investment strategy.
Even still, there are going to be individuals who haven’t received that update. Many individual investors are still stuck using the old investment strategy. They feel more comfortable with a “safer” portfolio even though that might not be the case.
It would be best to start by choosing a sustainable withdrawal rate. You may want to make an asset allocation of 40% to short-term, high-quality bonds, and 60% to a diversified global equity portfolio of 10-12 asset classes. For this type of setup, cash would be generated for distributions as the situation requires.
In a good period, when your equity assets have appreciated, distributions can be made by shaving off shares and then using remaining surplus to rebalance back to the 40/60 bond/equity model. And in a down market, your 40% allocation to bonds could potentially support distributions for up to 10 years before any volatile assets would need to be liquidated.
When you rebalance within equity classes, the goal is to enhance performance over the long term by strengthening a discipline of selling high and buying low as performance among the classes varies.
Rebalancing also involves analyzing the value of assets in your portfolio and selling off the ones that have exceeded the percentage given to them when you first structured your portfolio.
Investors who are not comfortable with risk may choose not to rebalance between bonds and stocks during down equity markets if they prefer to keep their safe assets intact. Doing this, however, may come at the price of opportunity costs.
In the low-interest-rate world that we live in, it’s easy for investors to become overly concerned with yield. However, even for retirement-oriented portfolios, a total return investment strategy will potentially attain higher returns with lower risk than invest-for-income approaches. This will potentially result in higher distribution potential, as well as increased terminal values.
