Keeping the Cash
Flowing in Retirement
By JONATHAN CLEMENTS
Staff Reporter of THE WALL STREET
You need a fork. What you've got is a knife and spoon.
Once retired, your goal is to generate a generous stream of income that
grows along with inflation and isn't threatened by market turmoil. But it's
tough to find that magical combination in a single investment.
Sure, stocks may provide long run inflation protection. But they usually
don't kick off much income and they can suffer wild share price swings.
Bonds, on the other hand, do yield a fair amount of income. But with the
exception of inflation indexed Treasury bonds, they don't generate rising
income, so they leave you vulnerable to inflation.
So how are you going to garner that generous, growing stream of income?
You need to settle on the right mix of stocks and conservative investments.
But that sure isn't easy.
Playing the Percentages
To understand how tricky all of this is, suppose you retire with
$400,000 and pull out 5%, or $20,000, in the first year of retirement. That
$20,000 would include any dividends and interest you receive.
In subsequent years, you step up your annual withdrawals along with
inflation. For instance, if consumer prices rose at 3% annually, you would
pull out $20,600 in the second year, $21,218 in year three and so on.
Doesn't sound like much income? True, if you withdraw 5% in the first
year of retirement and your portfolio returns, say, 6% or 7%, it might seem
like you are being overly conservative, because your portfolio will finish
the year 1% or 2% larger.
But in fact, if consumer prices are rising at 3%, the inflation adjusted
"real" value of your portfolio is shrinking. Meanwhile, with every passing
year, your withdrawals are climbing along with inflation. The one-two punch
of rising withdrawals and shrinking real portfolio values will eventually
deplete your portfolio -- if you live too long.
Still, you should be able to sustain a 5% withdrawal rate through a
lengthy retirement, provided your portfolio clocks around 7% a year over
the long haul.
"There's no way you can get that 7% from a bond portfolio, unless you
own the riskiest bonds," says Minneapolis financial planner Ross Levin.
"You've got to own some stocks. But that introduces a whole new set of
Resting on a Cash Cushion
Make no mistake: Stocks are a mixed blessing. You need to keep maybe
half your portfolio in stocks to sustain a 5% withdrawal rate. But if you
are not careful, your nest egg could be devastated by a stock market
plunge, as the combination of your own spending and slumping share prices
rapidly drains your portfolio.
What to do? If you get hit with big investment losses, immediately cut
back your spending until the market recovers. But even then, you will have
The reason: If you own 50% stocks and 50% bonds, your portfolio's yield
will probably be around 3%, after costs, far less than the sum you are
looking to withdraw.
In most years, you could garner extra spending money by selling stocks.
But if you did that during a bear market, you would be unloading shares at
fire sale prices. What's the alternative? Give yourself room to maneuver,
by building a cash reserve.
Based on a 5% withdrawal rate, you will consume roughly a quarter of
your portfolio's current value over the next five years. As a precaution,
take that quarter of your portfolio and stash it in short term bonds, money
market funds, inflation indexed Treasury bonds and certificates of
With this cash reserve in place, you are now free to invest the rest of
your portfolio for long run growth, by buying stocks and riskier bonds.
Each year, tap your cash reserve to pay your living expenses. Meanwhile,
look to replenish this reserve by regularly selling some of your growth
What if your growth investments are underwater? Don't do any selling
until these investments recover. With five years of living expenses in your
cash reserve, you should be able to ride out even a vicious bear
Buying a Monthly Check
Want even more room for maneuver? Consider buying yourself a hefty
stream of annual income, by investing a portion of your bond portfolio in
an immediate fixed annuity. Thanks to that extra income, you will have even
less need to sell investments each year.
With an immediate fixed annuity, you hand over a chunk of money to an
insurance company, in return for which you typically get the same sized
check every month for the rest of your life. As with bonds, immediate
annuities leave you vulnerable to inflation, unless you opt for an annuity
where the payments climb each year.
But annuities do help with other risks. Even if you mismanage or outlive
your other savings, you know you will get that annuity check every
Consider putting between 25% and 50% of your nest egg in an immediate
annuity, suggests Brian Birmingham, vice president of guaranteed products
at Prudential Financial in Florham Park, N.J. "There's a lot of peace of
mind and downside protection that comes from that," he says. "It allows you
to live through the stock market's ups and downs."