If you've ever worked with a mainstream investment advisor, you know they talk about a balanced portfolio of stocks and bonds, diversification, and the zigging-and-zagging of stocks and bonds that are expected to produce higher returns than just stocks alone--so-called risk adjusted returns. Those who go a step further may talk about a systematic withdrawal strategy from a balanced portfolio, generally around 4% a year (i.e., 25 years of straight-line expenses), as the plan for using the investment portfolio to generate retirement income. Historically that's worked over a 30-year retirement starting every year from 1926 or so, with maybe one small blip if you retired in the early 60s.
That 4% "rule" is based on a 50/50 mix of stocks and bonds. So if the market falls 50%, your portfolio will drop about half as much, maybe 25%, which could put a crimp in your withdrawals for a number of years while you await a recovery that is needed to get the plan back on track.
We call this an investment-based plan. The part the investment advisor doesn't tell you (if he or she is even aware) is that it works best if you are very well funded, that you have saved and can invest at least 30 or 40 times the amount you need to withdraw each year to cover your lifestyle. Or more. Not surprisingly, the more you have, the better it works.
If you need, say $100,000 a year to live on, and have $5,000,000 in your portfolio, you have 50x your annual need in savings. The advisor doesn't have to work very hard or be very good to make that work for a 30 year retirement--he or she just has to avoid events that would cut your portfolio in half or worse. And even then, there's a lot of cushion in a portfolio with a 50-year straight-line life.
For lesser mortals who are not funded 50x over their annual need, it's not quite so easy or simple. For one thing, a 50/50 allocation to stocks and bonds is totally arbitrary. It might work for an institution like a pension fund, but it ignores the realities of your household balance sheet.
What if the Upside risk capacity on your balance sheet--the amount your savings exceeds the present value of expected future liabilities--is only about 25%? If you put 50% in stocks (Upside), then you are risking 25% of your lifestyle (your Floor) in the stock market. That could be a big nick in retirement when the music stops on Wall Street, which it does about every ten years or so. Suddenly you have to cut your lifestyle by 15% or 20%, and maybe stay there for quite some time, if not for the rest of your retirement.
This is called sequence of returns risk, the risk that losses early in retirement can exhaust your portfolio because you need to keep withdrawing money to cover expenses from what becomes a declining total, thereby limiting how much it can eventually recover if and when the recovery comes. An investment-based plan has a way of beating a good household even more when it's down. Your lifestyle, like your portfolio, necessarily becomes smaller when that happens.
You need to be able to afford the risk the market offers in exchange for the possibility of gains. You need to have the risk capacity, the Upside, on your balance sheet to manage that risk so it can't beat you when you're down.
For those who are more constrained, who have may be 20x-30x their annual need in savings, we use a goals-based approach to manage household risk exposures throughout retirement, not an investment-based method that can fail when the market retreats.
Using goals-based planning, the household balance sheet gives us two key measures-Floor and Upside-and four risk management portfolios, instead of a single investment portfolio:
- Floor is the amount of savings in addition to Social Security, pensions, and other risk-free sources of income needed to cover the present value of all expected future expenses. The Floor portfolio prevents risk to lifestyle by hedging this amount from market and inflation risk over the 30-year retirement period by investing in risk-free inflation adjusted securities like TIPS bonds.
- Upside is the amount of savings that exceeds Floor and Reserves, and so can be invested in risky assets like stocks for long-term growth without jeopardizing lifestyle (the Floor). We do this most efficiently by investing the Upside portfolio in a global market portfolio of stocks, diversifying away the specific risk of owning individual business, while retaining market risk and its year-in, year-out market returns.
- Longevity is a portion of Floor carved out to provide longevity insurance, which is additional guaranteed income that you cannot outlive and which can support a weak and failing portfolio, especially late in a plan. The overall strength of a balance sheet is an indicator of how large the Longevity portfolio should be. Longevity risk is managed by pooling the risk in a low-cost guaranteed income insurance product-a deferred income annuity, typically a low-cost QLAC bought with deferred savings from a 401(k) or IRA that also helps reduce taxable required minimum distributions by deferring the income until later in the plan.
- Reserves is cash set aside for current and unexpected expenses, calibrated to 1-3 years of annual need. It provides necessary liquidity away from all risks except inflation, which is why it is limited to just a few years of expenses. Reserves avoid most financial risk, while providing a short-term liquidity cushion.
Here's a look at how this math works-it's not arbitrary, it's right off the household balance sheet:
Total savings is $674,000. The Income Floor (PV of Expenses - Social Security/Pensions/Earnings) is $388,599. With 10% of savings allocated to Longevity, $67,400, the remaining Floor is $321,199. Reserves of $69,033 here represents 1-1/2 years of annual expenses needed from savings.
When Floor, Longevity, and Reserves are subtracted from savings, we get $216,368 as the surplus-that's the Upside that can be exposed to market risk for growth while Floor, Longevity and Reserves are protected.
The resulting goals-based allocation is 32.1% Upside, 47.7% Floor, 10% Longevity, and 10.2% Reserves. That's considerably different from the arbitrary, cookie cutter allocation of 50% stocks, 50% bonds (or the more common 60%/40%) that falls out of the investment-based plan.
The goals-based balance sheet method works so well, we use it even for the well-funded, with the major difference that Upside is larger than with a more constrained balance sheet, and that we might use some bond funds in the Floor instead of just a ladder of CDs and TIPS bonds.
You can learn more about the household balance sheet by visiting the Retirement Income Industry Association website.
Let me know if you have any questions!
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.