R101 #7 - How to use Investments to Fund Retirement
In the last post I discussed how to know if your retirement is funded or not. If you’ve determined that you have sufficient guaranteed income, or enough investments to fund your retirement without taking any market risk, then you’re in a really good spot. This is the situation many retirees used to be in back in the day.
That’s not the situation for the majority of retirees today and going forward. Most can’t just invest in government bonds and dividend stocks and live off the income like my grandma did. Investing for income isn’t what it used to be.
So how do you turn a pile of money into an income stream that will cover your expenses for the next 30+ years?
As I mentioned before, for those who are averse to market risk, they may feel drawn to handing all that money over to a company that guarantees them a certain level of income for the rest of their life. That’s why annuities sound good on the surface. We’ll cover those in the next post.
Let’s assume you don’t want to do that. The financial advice industry has come up with lots of strategies to use to encourage investors to feel comfortable using an uncertain investment portfolio to fund their retirement. You may have heard of a few like the “4% rule”, the “bucketing strategy”, a “bond ladder”, “time segmentation”, “spending guardrails”, or the “buffer strategy”.
Spoiler alert: there is no perfect strategy. Most advisors have a favorite strategy, though. You might want to ask what theirs is.
What I’ve found is that “right” strategy for a particular client is the one that allows them to balance living their lives today, sleeping well at night, mitigating their risk of running out of money, and allowing them to reach their other financial goals throughout the rest of their lives. Let’s talk about how some of the strategies above may (or may not) meet those criteria.
First, you need to understand the different ways that investments can provide “income”. Depending on what type of investment you have, you may earn interest or dividends. That’s what most people think of when they consider investment income. The other way investments provide return is through gains in value over time. You can then sell the investment for more than you paid. The idea of “total return” on a portfolio includes all of these components. The assumption is that the more risk you take in your portfolio, the more return you can realize. All of the approaches are a way to balance the risk and return of your portfolio so that you can take withdrawals over time to fund your retirement.
The 4% Rule
What it is - this strategy was based on research that was done to find out what percent of a portfolio could be safely withdrawn each year without running out of money during a 30-year retirement horizon.
Why people like it - people like the simplicity of this approach and the sense of security and consistency it provides.
Why it might not work - the research was based on historical data using lots of assumptions that may or may not be true in the future and could lead to the rate being too high. The 4% was also based on the worst-case scenario, and in many cases, would lead to the rate being too conservative.
The Bucketing Strategy (and similar strategies like the Buffer Strategy)
What they are - these strategies all seek to reduce the risk of the total portfolio by splitting your investments into portions that are less risky and those that are more risky.
Why people like them - having some assets that are not subject to market risk helps people sleep better at night because their near-term spending needs are covered by funds that aren’t going up and down in value as the market changes. These strategies also help with sequence of returns risk to avoid pulling from investments that have declined in value.
Why they might not work - it can be hard to implement these strategies because you have to decide how much money to put into the less volatile buckets or buffers. You may not have enough assets to comfortably assign enough to the non-volatile portion. You may also struggle with when to “refill” these buckets when the market declines.
The Bond Ladder (and similar strategies like Time Segmentation)
What they are - the idea of these strategies is to match return/income on assets to the time period where you need to withdraw the funds for retirement. For example, you have portions of your portfolio with shorter time horizons (and likely lower return), and portions with longer time horizons.
Why people like them - these strategies are nice because they allow you to be able to count on the income/return from the investment for that particular period of time. Your one-year bond is going to pay you interest and return your principal at the end of the year.
Why they might not work - time-based strategies require you to dedicate investments to that portion of the portfolio just like the bucket strategies. You are subject to interest-rate risk because you don’t know what return you will be able to get when you have to add the next part of the ladder or time segment.
Spending Guardrails
What it is - this type of strategy focuses more on the withdrawal amount from the portfolio like the 4% rule, but requires modifications to the withdrawals based on the performance of the portfolio over time.
Why people like it - it answers the question of “how much can I spend” that retirees are always asking. It allows for flexibility over time as needs change.
Why it might not work - some people don’t like the idea that they may need to reduce spending over time if their portfolio drops. Depending on how much slack is in their budget, they may not be able to cut back much.
The reason there is no “best” strategy is that no one strategy is objectively, numerically, superior because the future is uncertain. There is also the element of human behavior and preference that may lead one strategy to be better for one person over another. I like to use a combination of strategies that are “good enough” from a pure analytical sense, will allow retirees to enjoy their lives, sleep better at night, and maintain/adjust the strategy going forward as they age and the uncertain future becomes reality.
Next up - annuities. Not the dirty word or perfect solution you may think they are.
