Build Your Retirement Portfolio to Last

Updated May 21, 2009

Rande Spiegelman
CPA, CFP®, Vice President of Financial Planning, Schwab Center for Financial Research

In Spending Confidently in Retirement we looked at how big your portfolio should be to sustain your level of retirement spending (other sources of income taken into account, of course). If you’re a conservative-to-moderate investor in retirement and want a high level of confidence that you’ll maintain your inflation-adjusted standard of retirement living for 30 years, the rule of thumb is this: Shoot for a portfolio approximately 25 times as large as your first-year withdrawal. This translates into roughly a 4% withdrawal rate in the first year of retirement only. After that, the goal is to increase the first-year dollar amount to adjust for inflation each year throughout retirement.

Why not go conservative?

If the portfolio target for the same level of spending is about equal whether you take a conservative or moderate investment approach, then why should you take on more risk for a similar probability of success? Why not just go conservative? Because, in addition to spending confidence, you might also want to increase your odds of ending up with more than you bargained for.

If you are a conservative, moderately conservative or moderate retiree, you can withdraw roughly 4% of your portfolio’s value in your first year of retirement and adjust that amount for inflation over a 30-year period with about a 90% probability you won't run out of money prematurely. However, without sacrificing the 4% inflation-adjusted withdrawal rate, if your investment approach is moderately conservative or moderate, you have the chance to end up with more money, as the following table shows:

Potential ending wealth for a retiree with a 30-year horizon

Hypothetical examples are for illustrative purposes only and not intended to be reflective of actual results. Ending wealth assumes 2.7% inflation.

OK, so why not go moderate?

Before you answer based on the best-case scenario in the table above, notice that it’s based on a 25% confidence level—that is, 75% of the outcomes are expected to be worse. What's more, a moderate portfolio, being riskier, is more likely to run out of money prematurely if we boost the confidence level to 95%.

How soon might your money run out at a 95% confidence level?

Splitting your retirement into stages

Ultimately, the best asset allocation for your retirement portfolio will depend on your own circumstances and tolerance for risk. If you are a retiree who relies on your investments for a significant portion of spendable income and want your portfolio to last as long as you do, we recommend that you allocate at least 20% (conservative), but no more than 60% (moderate), to stocks. Many retirees might find a moderately conservative allocation in the middle of that range (40% stocks) appropriate, given the goal of balancing sustainable current income and potential long-term growth.

Of course, there’s no rule that says you can’t change your allocation over time. In fact, it’s generally a good idea to do so. For example, let’s say you’re 60 and you expect to live at least 30 years in retirement. As your retirement time horizon gets shorter and your needs change, you may decide to position your portfolio more conservatively. After all, the need for long-term growth should diminish as life expectancy becomes shorter. Why take more risk than you need to, assuming sustainable spending is your primary goal?

How you might reposition your retirement portfolio over time

The shift to a more conservative allocation doesn’t necessarily occur at a specific point in time. In practice, it’s a good idea to move gradually, adjusting your portfolio along the way to suit your circumstances and ever-changing time horizon. You could even decide to put such allocation shifts on autopilot, through the use of a retirement “target” mutual fund.

Set aside some cash as a cushion against bear markets

No matter which asset allocation you choose to start with, try to set aside enough cash in a money market fund, savings account or short-term certificates of deposit (CD) to cover your spending needs for at least one year (minus what you expect from your non-portfolio sources of income, such as Social Security, pensions and so on). If you can, consider placing an additional two to four years’ cash in longer-term CDs, a deferred fixed annuity, ultra-short bond fund or high-quality short-term bonds.

As long as your portfolio performs as expected, you can keep rolling over these investments. But in the event of a long bear market, you can cash them out instead of having to withdraw from the equity component of your retirement portfolio at the worst possible time.

Sensible ways to manage your retirement portfolio

With your short-term cash cushion in reserve and an additional cushion within the fixed income portion of your asset allocation, here are some sensible ways to manage your retirement portfolio:

• Diversify your portfolio across and within asset classes. For more, see The Portfolio Pyramid: How To Diversify Your Investments.
• Consider a “laddered” mix of high-quality bonds or bond funds with maturities of one to seven years.
• Keep tax-efficient investments in taxable accounts. This includes stocks held over one year, tax-managed funds, index funds, qualified-dividend-paying stocks and mutual funds, and municipal bonds (if they make sense for your tax bracket).
• Keep tax-inefficient investments in tax-deferred accounts. This includes stocks held one year or less, actively managed funds, taxable bonds and real estate investment trusts (REITs). For more, see Tax-Efficient Investing Is More Important Than Ever.

Cash flow in the first 10 years

For many retirees, the first 10 years of retirement are the most active, which can translate into higher spending needs. It’s also the time when a bear market can have the biggest impact on the future value of your portfolio because potential compound growth is lost.

Here’s one solution for even more reliable income (and a higher portfolio confidence level) during the first 10 years of retirement: Take perhaps 25% of your fixed income allocation and buy a ladder of high-quality bonds, CDs and/or a low-cost immediate fixed annuity with staggered maturity dates (a structure know as a ladder) designed to pay out for a certain period—10 years, for instance.

There are any number of alternatives. Just make sure to crunch the numbers based on the available fixed income options, current interest rate environment and your risk tolerance, comfort level and objectives.

Hypothetical example: cash flow in the first 10 years of retirement

• Early retiree, age 55
• Moderate investor: 60% stocks, 40% fixed income
• Expects 6.9% total annual return
• $1 million portfolio
• Needs $40,000 total cash flow in the first year of retirement; this amount is adjusted up for 2.7% inflation each year after that)
• Wants to ensure annual cash flow of at least $12,000 for the first 10 years of retirement

Take $100,000—25% of the fixed income portion of the portfolio—and purchase an immediate fixed annuity that guarantees annual payments for the next 10 years. Or, set up a ladder of high-quality bonds and/or CDs for the same period. Assuming an average interest rate of 3.5%, either option is likely to provide cash flow, a total return (interest and principal) of $12,000 per year for each of the first 10 years of retirement (leaving $0 of the original $100,000 at the end of 10 years).

Our retiree now has $12,000 of the $40,000 needed in the first year of retirement. The other $28,000 comes from the rest of the portfolio, now worth $900,000. By the time the first 10 years are up, Social Security kicks in. Here’s what the retiree’s cash flow might look like, assuming the portfolio generates a 6.9% average annual long-term return and inflation expectations stay constant, at 2.7%, year to year:

* Cash flow increases every year to adjust for 2.7% inflation.**$1 million beginning portfolio, less $100,000, equals $900,000. End-of-year values shown, assuming withdrawals at the beginning of the year. Hypothetical example for illustrative purposes only.

Of course, we know that in the real world “average” annual returns are just that—average. From year to year, actual returns could be all over the map. That’s why it’s a good idea to incorporate potential volatility into your long-term planning with a Monte Carlo probability analysis, and then stay flexible over the shorter term (where anything can happen).

What parts of your portfolio should you draw from, and when?

We’ve covered the first two steps of long-term retirement planning: how much you need to spend and how you might structure your portfolio for the long term. But some sticky questions remain regarding the short term. What’s the most effective way to draw down your retirement portfolio each year? Where does the money come from?

Next: Generating Cash Flow from Your Retirement Portfolio

As always, if you have questions or need help, please contact your Schwab consultant. If you're not yet a Schwab client but would like to learn more, a Schwab consultant can help. Call 800-435-4000 to get started.