Constructing an income stream for retirement is not unlike constructing a residence or commercial structure. An architect and contractor must understand the challenges presented by the regional geology and specific soil composition around the building. Possession of this critical knowledge guides the decisions about materials used and changes that must be made in the construction process.
One of the great risks that may undermine anyone’s retirement cash flow is inflation. After World War II, the basic strategy was to accumulate a number of bearer bonds.1 The coupons would be regularly clipped from the bonds and cashed at the nearest bank, providing predictable income. However, as economic growth and price inflation increased, investors were forced to seek a broader spectrum of products with which to build their retirement income.
Four Elements of Retirement Income
Modern retirement portfolio theory calls for individuals to think of income being derived from interest, dividends, capital gains, and liquidations of principal. This portfolio theory is promoted in trade magazines2 and popular local radio financial shows.3
The basic approach is to have a cash account established with a brokerage firm or bank that has a working relationship with a brokerage firm. Interest from accounts such as CD’s, bonds, or a money market account generate monthly interest deposited into the cash account. Stock based mutual funds, stock in individual companies, Real Estate Investment Trusts, Closed End Investment Funds, and others produce regular dividends that are also deposited into the cash account. Finally, capital gains produced within the account (profits from the sale of individual stocks and bonds or profits generated by investment companies) are collected in the cash account as well.
The basic approach of many advisers and financial planners (although this is not an unanimous position) is that it is safe to begin retirement by withdrawing four percent of the total asset value of the consolidated investment account in the first year of retirement. With a portfolio adequately diversified between investment classes and approaches, the plan is for the income to grow matching inflation with capital gains generated sufficient to allow reinvestment for potential growth in the portfolio value. At least annually, retirees should consult with their adviser about the sufficiency of income being produced and potential reallocation of assets.
As mentioned earlier, there is also the possibility of spending account principal to produce the required retirement income. There are two scenarios for this under the portfolio theory. The first is in years when dividends, interest, and capital gains are insufficient to provide the necessary cash for planned income. Consultation with an adviser is recommended, because which investments may best be liquidated in whole or in part is of paramount importance. The other scenario is when the retirees initial goal is to use the money in retirement. Some retirees considered, “The perfect retirement plan was one where the last check was for the undertaker – and it would bounce.”4
The potential problems in this plan are many. What happens if you live longer than your plan, and you have no more money? What happens to your family if the check to the undertaker bounces? In most states, nothing can be done until the funeral arrangements are paid. No one wants to create a situation where your children or grandchildren have to sell their possessions to pay your debts! Thus a critical element to every retirement portfolio is managing the cash annually withdrawn and the timing of any potential asset sale.
Managing Your Emotions is a Full Time Job
Investing (for retirement or not) is often an emotional roller coaster. Some find themselves flush with confidence about their prowess in assessing and selecting investment opportunities. Often such overconfidence results in too frequent trading and excessive costs draining any profits. Others are torn between unrealistic expectations of continuous upward values and excessive fear of market downturns. These investors make rushed purchases on the belief that they may miss out on the way up, only to sell their purchases when prices are down.5
Emotions cannot be entirely excluded from investment decisions any more than in other phases of life. We can only learn to manage them. One important step is to analyze and codify the items that should limit certain investment options. Some may believe investing in foreign stocks or bonds is unpatriotic. Others may sense an distinct discomfort about investing in small companies, or those who are not socially conscious. Developing a “personal profile” of your individual or family risk tolerance is an important step in managing your investment emotions.
Constructing a portfolio for retirement income is a matter of management. We must manage how the income is derived, how much income is annually withdrawn, how much is withdrawn at any one point in time, and how our emotions affect our investment decisions. Preparing for the process before retirement is a plus!
1 Kitches, Michael. Kitches: The 4 pillars of portfolio management. May 15, 2017. http://financial-planning.com.
2 Kitches, Michael. ibid.
3 Wieniewitz, Trae. Right on the Money. July 2, 2017. WOKI Knoxville, Tennessee.
4 Kitches, Michael. op.cit.
5 Statman, Meir. An Expert Explains the Right Way to Be Emotional About Your Investments. May 31, 2017. http://time.com/money.