You’ve spent most of your life saving for retirement. Now you’re finished working and it’s time to start spending what you’ve saved. For many investors, the transition can be confusing or even traumatic. How will you tap your portfolio?
As you approach this transition from saving to spending, take into account three steps:
Start with a retirement income plan.
Keep your portfolio invested and diversified.
Rebalance your portfolio periodically to generate the cash you require.
Here we’ll discuss the last step, creating cash flow through rebalancing.
Why is this important?
If you’re an investor, you’ve probably heard that you should build a portfolio with an appropriate asset allocation to stocks and bonds—for instance, 60% stocks and 40% bonds—and then rebalance it periodically. Rebalancing is necessary because over time, your asset allocation can drift from its original target. As some investments gain in value and others lose value at different times under different market conditions, their relative weightings within a portfolio will change. Rebalancing helps restore your allocation to its original target, and helps keep your portfolio in balance based on your goals and tolerance for risk.
Few investors think of rebalancing as a retirement income strategy. In fact, many investors try to construct a retirement income stream from investment earnings alone, but it may not be necessary or even efficient. For instance, today you’d need a portfolio of more than $2 million, invested in the stocks in the S&P 500® Index, to generate $40,000 in dividend income, based on the current dividend yield of the S&P 500.¹ You could push more into investments with higher income yield, but doing so involves higher risk. For many people a more feasible strategy is to consider a diversified investment approach that includes, but isn’t limited to interest and dividends, instead—and rebalance.
How do you do it?
Consider John and Jane. They’ve been diligent savers and have built a solid balance to tap now that they’ve decided to retire. They’ve worked with a financial advisor, and determined that they’ll likely have a long life in retirement. They have $1 million saved and want to start retirement by tapping $40,000 from their portfolio before taxes, which they’ll supplement with Social Security payments and other income.
John and Jane start with mix of cash, bonds and stocks recommended by their advisor. They’re in their mid-60s, and this mix of investments is suitable for their situation and feels comfortable to them. A year from now, they plan to take their first portfolio withdrawal. Today, their portfolio looks like this:
Source: Schwab Center for Financial Research. Hypothetical for illustration only. Your asset allocation likely will differ depending on your time horizon, risk tolerance, and other factors.
After a year in the market, what happens? Let’s imagine that the portfolio performed reasonably well, as shown below:
Note: Returns illustrated are one-year returns, hypothetical for illustration only.
There are two nice attributes of interest and dividends: One, most portfolios generate them, and two, they’re always positive (that is, they’re never less than zero). However, they might not be enough, on their own, to generate the income you need. For John and Jane, portfolio growth boosted their return, which provides a third portfolio income stream in addition to what they’re getting from interest and dividends. This may not happen every year. But on average, we expect that a diversified portfolio will grow over time.
Now that we see how their portfolio performed, how do they generate the cash they need? They rebalance, as shown below:
In this case, John and Jane chose to invest using mutual funds and exchange-traded funds (ETFs). They opted to automatically reinvest the distributions they received. At the end of the year, John and Jane rebalanced and sold shares to generate the $40,000 they needed.
What else could you consider?
Interest and dividends vs. selling shares? John and Jane could have chosen to have interest and dividends transferred to a bank account first, and then sell shares if needed. For example, if they received $20,000 in interest and dividend payments—equal to 2% yield from their $1 million—they’d only need another $20,000 more from their portfolio. It can be easier, though, just to reinvest and keep the money working. This can also make the paperwork easier.
Tapping “principal”? Some investors look at rebalancing and selling investments as tapping principal. Think of it instead as tapping all sources of return from your portfolio as well as a portion of your savings, if required. Using John and Jane’s scenario, they didn’t tap any of their original $1 million principal—they simply used the portfolio gains as additional portfolio income.
Down market? The risk of a down market is critical to retirees. Early in retirement, a big drop in your portfolio can be particularly damaging. A diversified portfolio with an appropriate mix of cash, high-quality bonds, and stocks helps with diversification, but it’s not a guarantee that your portfolio won’t lose value. In a down market, consider cutting discretionary expenses, if you can. Do this, and you may limit the need to sell investments in a down market.
What about taxes? Consider the tax implications of withdrawing income from your portfolio. For example, it typically makes sense to avoid selling any shares purchased within the last 12 months to limit short-term capital gains tax treatment. In addition, earnings withdrawn from a traditional IRA or 401(k) are taxed as ordinary income. Withdrawals from Roth IRAs or Roth 401(k)s are not taxed at all. As part of your rebalancing and distribution strategy, speak with a financial planner or your tax advisor about the most efficient distribution plan.
A trap some retirees can fall into when it comes to retirement income planning is limiting their strategy to interest and dividends and neglecting the power of rebalancing to capture portfolio growth as an additional income source. In addition to helping you take a more holistic approach to generating income, it has the added benefit of forcing a good habit of regularly rebalancing your portfolio back to its intended asset allocation based on your goals, time horizon and risk tolerance—an important fundamental of successful investing and one that’s even more critical for people approaching or in retirement.
¹ Source: S&P Dow Jones Indices. The dividend yield of the S&P 500 Index was 1.79% as of 3/7/2018.