How to Create a Sustainable Retirement Spending Plan

Key Points

  • When shifting from saving to spending your retirement funds, use multiple building blocks to help generate cash flow.
  • While interest and dividends can be one source of income, don't let them drive your retirement spending.
  • After non-portfolio income sources such as Social Security, part-time work, a pension or an annuity, we suggest using cash and short-term investments, interest and dividends, and capital gains to help fund your spending needs.

As you get ready for retirement, your focus will likely start to shift from saving to spending. For many making this transition, a crucial question is: How do you set up a  spending plan that lets you hang on to as much of your nest egg as possible even as you regularly tap your investments to support upcoming spending needs?

While some investors hope to make interest and dividend income their only source of funds for retirement spending, that strategy isn't necessary or even optimal for most investors. Interest or dividends alone may not provide the income you need—especially in a low-rate environment.  And they don’t need to. 

We recommend using your entire portfolio, including tapping into short-term reserves and regularly harvesting capital gains, if necessary. When applied to a portfolio that has the right building blocks of retirement income, this approach can help you create income, grow assets to help manage inflation, and provide liquid capital to weather a market downturn, if necessary.

Using the building blocks for cash flow

The illustration below shows how we would suggest setting up such a portfolio. It isn’t a major departure from what you’re likely used to.

Using the building blocks for cash flow

Source: Schwab Center for Financial Research.

We suggest setting aside in a bank account any cash you will need for the next six to 12 months. This is your "current spending" bucket, which needs to be refilled from time to time, generally through portfolio rebalancing.

Rebalancing means that you will periodically—twice annually tends to be a good frequency—sell investments that have appreciated to purchase investments in areas of the market that have fallen in value. You do this to stay in balance with your targeted long-term strategic asset allocation. It also enforces what you might not do naturally: buy low and sell high.

Rebalancing is also helpful when funding distributions. When you sell appreciated investments, you can use some of those capital gains to replenish both your current spending and "short-term reserve" buckets. If you keep these buckets full, you are less likely to have to sell investments during a down market in order to fund your current spending needs.

You might also consider depositing interest and dividends into your current spending bucket or your short-term reserve bucket, though many investors may choose to reinvest interest and dividends to help compound returns.

Put a plan into action

How do you generate income and keep your bank account sufficient in practice? Consider a hypothetical couple, John and Nancy, with a $1,000,000 portfolio. They need $50,000 per year in cash flow from their portfolio, after Social Security and other income sources.

Instead of fixating on yield from income-oriented investments, how might they fund their spending needs in retirement?  In the example below, John and Nancy choose to use interest and dividends as a first source of spending. Then they tap cash or short-term investments or capital gains, as necessary.

  • $25,000 from interest and dividends. John and Nancy earned a yield of roughly 2.5% on the investments in their entire portfolio last year, and anticipate roughly the same next year. This would deliver $25,000 in relatively predictable—though not fully guaranteed—income from interest and dividend payments.
     
  • $25,000 from cash and short-term investments, or capital gains. This is where a periodic rebalancing discipline helps. In a significant down market—for example, 2008, when the S&P 500® Index fell a heart-wrenching 37%—John and Nancy could tap $25,000 from their cash reserve and short-term investments. In contrast, in a year where their portfolio rose significantly in value, John and Nancy might have used capital gains from their stock portfolio to bring their portfolio back into balance, while simultaneously either replenishing their cash reserve and short-term investments or funding spending needs.

This is a simplified example of how the combination of interest and dividends, capital gains, and cash investments and short-term reserves can be used to fund spending.

John and Nancy could also choose to reinvest interest and dividends, and jump straight to funding spending using cash and short-term investments, or capital gains, by rebalancing their portfolio periodically.

You can personalize the details of your spending plan to address your unique needs, including issues such as required minimum distributions (RMDs) across accounts, tax issues, and other factors.

What to do now

We suggest you structure your portfolio so it can deliver cash flow from a variety of building blocks when and how you need it, without giving up growth potential. This is the essence of modern retirement portfolio and distribution management. The key is to build a portfolio positioned to support current spending and future needs.

I hope this enhanced your understanding of creating a sustainable retirement spending plan. I welcome your feedback—clicking on the thumbs up or thumbs down icons at the bottom of the page will allow you to contribute your thoughts. (If you are logged into Schwab.com, you can include comments in the Editor's Feedback box.)

Next Steps

Talk to Us

To discuss how this article might affect your investment decisions:

-          Call Schwab anytime at 877-338-0192.
-          Talk to a Schwab Financial Consultant at your local branch.

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Important Disclosures