The Retiree's Guide To Portfolio Management

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 |  Includes: BSV, JNJ, KO, NLY, PG, VIG, VNQ
by: Skyler Greene

"Retirement investing" is a fairly broad term, because it covers all investors with a 401(k), IRA, or similar retirement account. That means most of us are retirement investors, whether we're a 20-something starting our first corporate job or a 70-something actually in retirement.

Many of my previous "retirement investing" articles have focused on the dividend growth investing strategy, which is a solid way for all pre-retirement investors to grow their nest egg over time. However, some commenters have called for an article on how retirees should invest:

[Skyler], howsabout posting your strategy for (1) those of us who are already retired, as opposed to (2) those of us who are still working toward retirement. There is a difference in investing strategy, and it's mostly about the amount of risk that the two groups can tolerate.

- Grumpyoldcoot

So I decided to give it a shot.

Introductory Notes

As you're reading, please do keep in mind that I'm not a registered financial advisor, and remember that you should do your own research and consider your own personal situation before making any financial decision -- especially one as major as managing your retirement portfolio.

The following analysis applies to assets in a traditional tax-deferred IRA. For information on RMDs and other IRA rules, see this IRS document. To calculate RMDs, try this handy little calculator from FINRA.

What Are You Looking For?

Most retirees are looking for preservation of capital, for obvious reasons. For this reason, the easy and simple suggestion is to stick it all in short term bonds. But this strategy, to me, is a little short-sighted. In the current environment, short-term bonds are unlikely to return more than 2%. However, with good risk management and a smart portfolio allocation, your portfolio can likely achieve higher returns. As you can see from the table below, if you can squeeze a 4% return out of your portfolio, it will enable you to preserve significantly more wealth for yourself or your heirs -- and give you more income!

click to enlarge images

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I've constructed a strategy which I believe does a fairly good job of balancing capital preservation with portfolio maintenance/growth. If you follow this strategy, you'll be able to capture some market gains, while still ensuring that you'll have plenty of available cash-or-equivalents to make necessary withdrawals. This strategy, which I'll call "Skyler's Strategy," is tailored to the current low-interest-rate environment and aims to balance safety and capital preservation with return.

Skyler's Strategy: The Basics

There's a little bit of math involved here, so bear with me. Once you read through the whole article, I promise the strategy's workings will become clear.

The first thing you need to is calculate the distributions you'll be taking for the next seven years. For each year, this figure should be the higher (the "max value") of:

  1. Your RMD (Required Minimum Distribution) based on your account balance. Assume your account balance will remain constant for the next seven years.
  2. The amount of income you think you will need above and beyond other sources (pensions, Social Security, etc). I will call this figure EWN (Estimated Withdrawals Needed). I would recommend being generous with this calculation -- it's better to be a little "too cautious" rather than not cautious enough. When calculating this income, remember that withdrawals from an IRA are taxable and adjust accordingly. If you expect to be in the 25% tax bracket, and you need an after-tax withdrawal of $4,000, you would actually need to withdraw $5,333 to cover your $4,000 income requirement and the corresponding $1,333 tax bill.

Here is an example of what your calculations would look like if you're aged 71 currently and your portfolio size is $100,000.

The reason this calculation is important is that you want assurance that you will be able to make your needed withdrawals -- we're setting aside (preserving) capital to guarantee withdrawal ability.

Here's how we're going to set up the "safe" part of the portfolio.

The sum of the "max" value (the higher of the EWN or RMD) for your first two years should be held in cash. I recommend adding a 10%/year buffer to this value -- so in our hypothetical example, the sum of the "max" value for the first two years is $8,400, and the sum after a 10%/year buffer is $9,240. Thus, you should hold $9,240 in cash. Doing this guarantees that your withdrawals for the next two years will be available in cash.

Now let's look at the withdrawals for years 3 - 4 -- in my chart, year 2014 and 2015. The sum of the "max" values for these years should be held in very short-term (1-3 year) high-investment-grade bonds. High-investment-grade means U.S. Treasury Bonds, very highly rated (AAA or AA) corporate bonds, or any investment of equivalent duration and credit quality. Since interest rate risk is eliminated if bonds are held to maturity, you can rest assured that capital will be entirely intact -- with nominal interest -- at the end of the "duration" of the holding. Since we've already guaranteed ourselves our next two years' withdrawals via the cash holdings above, it's okay to go out to up to three years on the bonds, because we have no interest in using this capital until then. In our example, then, $4,200 + $4201.68 = $8,401.68 should be invested in these short term bonds or CDs. Again, giving ourselves a little buffer, let's round up to about $9,000.

Finally, let's look at the withdrawals for years 5 - 7, corresponding to 2016, 2017, and 2018 in my chart. By holding enough cash to tide us over for two years, and enough short-term bonds to tide us over for another two years, we've given ourselves peace of mind for the next four years. Thus, we can allocate the sum of the remaining "max" values, plus a little buffer, to intermediate-term bonds (3-5 year maturity). Since preservation of capital is the primary goal here, look for high-investment grade just like we did in years 3 - 4. Adding up the "max" values and adding a little buffer, let's put $15,000 into these intermediate term bonds.

Review: What We've Done So Far

We've guaranteed our ability to make necessary withdrawals for the next seven years. Our investments are either cash or "cash equivalents" that will be worth par value or more when we need to withdraw them.

The Next Step

So far, we've set aside $33,240 in cash and safe "cash-equivalent" assets. This leaves us with over $66,000 that we can invest for growth.

Here's how I recommend investing that remaining $66,000.

  • ~75% in "blue-chip" dividend-yielding stocks. These stocks are relatively stable performers. As you can see from the chart below, blue chips like Procter & Gamble (NYSE:PG), Coca-Cola (NYSE:KO), and Johnson & Johnson (NYSE:JNJ) weathered the financial crash with minimal damage done to stock price -- and as I'll explain later, the dividends provide another important line of defense.
  • ~20% in high-yield bonds. As I explained in High Yield Can Be Your Friend, a professionally-managed high yield bond fund can provide predictable >6% annual coupon payments. Over the long term, high-yield bonds provide equity-like returns with about half the volatility.
  • ~5% in REITs. While rather volatile, REITs provide strong return in the long term, and generally have good dividend payments. An investor with especially strong risk appetite could look into a high-yielding mREIT like Annaly Capital Management (NYSE:NLY), but as such mREITs are even more volatile than other REITs, I would not recommend them in most cases.

Given our ~ $66,760 investment budget, this works out to roughly $50,000 in blue chip dividend stocks, $13,000 in high-yield bonds, and the remaining $3,760 in REITs.

PG ChartClick to enlarge

PG data by YCharts

Managing Skyler's Strategy: Future Years

After reading this section, the strategy's working will hopefully become clear to you. Our goal is to capture market gains in up years, but never to sell in down years. Here's how we accomplish this: in any year when the market is up, we replenish our cash by selling invested "growth" assets -- the REITs, junk bonds, and dividend stocks. Given a needed withdrawal of $4,200 for the first two years, we need our $66,000 to return approximately 6.3% to replenish the cash fund. In a good market, this shouldn't be too hard to accomplish between capital gains and dividend payouts.

On the other hand, what if the market is down? In a down year, use remaining cash or "safe" investments (bonds) to fund withdrawals. Since we have seven years of safe investments, we don't have to worry about selling during a down market in the short term -- we've got our withdrawals safely covered. In the meanwhile, our invested $66,000 is getting a 3%+ dividend (assuming 2.5% for stocks/REITs and 6% for high yield bonds) reinvested at lower prices. When the market comes back up, these assets can be sold to replenish cash and any bonds used.

What about the scenario where a down market lasts 7+ years? I personally find it highly unlikely that such a situation would occur. However, even if it does, remember that our investment has netted 3% dividends every year. Thus, at the end of 7 years, we'll have been paid at least 21% in dividends, meaning that as long as the market's decline isn't more than 21%, we can sell the whole lot and still break even. (This ignores dividend reinvestment, which is a powerful force in a down market, enabling you to collect more shares and thus more dividends. If you factor this in, we have even more downside protection.)

Further Analysis and Notes

This portfolio seems to work well for investors in their early to mid 70s, but it will have dwindling returns as you get older, as RMDs will continue growing. The required seven-year "safe reserve" thus grows larger over time, decreasing the percent of capital you can keep invested in stocks/bonds/REITs. Of course, this may not be as much of an issue if your real-life portfolio is larger than $100,000.

The method I described is a general framework -- you can obviously customize it to your personal situation. If you have significant assets and multiple other sources of income, you may have more risk tolerance. In this case, perhaps the "safe reserve" could be reduced to 4-5 years. On the other hand, if your retirement portfolio is the primary component of your retirement income, you may wish to increase the "safe reserve" by a year or two.

While I recommended bonds for the non-cash portion of the safe reserve, you could theoretically use Certificates of Deposit (CDs) as well.

In my article Hidden Cost of Mutual Funds: Why Dividend Investors Should Go It Alone, I ran calculations and concluded that for long-term investors, holding individual dividend stocks is cheaper than investing in a mutual fund. These calculations were based on limited trading activity each year. However, under Skyler's Strategy, retirement investors will be reducing their equity holdings to replenish cash reserves on a fairly consistent basis. For those with smaller portfolios, the cost of executing lots of individual trades may outweigh the expense ratio of a mutual fund or ETF. Do your own calculations to determine which is more cost-advantageous. The Vanguard Dividend Appreciation ETF (NYSEARCA:VIG) currently offers a very cheap 0.13% expense ratio, which equates to $65 a year in expenses on the $50,000 invested capital. (If you hold a diversified portfolio of stocks, commissions on individual stock selling will likely be more expensive than $65 a year.)

For the bond holdings, I definitely recommend a mutual fund or ETF that allows you to easily trade in and out. A potential ETF of interest is Vanguard Short Term Bond (NYSEARCA:BSV). For the REIT holding, I recommend the Vanguard REIT Index (NYSEARCA:VNQ) or a well-managed mutual fund with low expense ratios.

While this article was written with traditional IRAs in mind, a similar strategy could be used in a Roth IRA. Just forget about RMDs and instead use your "required withdrawals."

Finally, it's important to note that you may need to rebalance investments each year, as your seven-year projections of withdrawals will change. In a down market, you can use cash and bonds to fund withdrawals, but be sure to replenish these "safety holdings" as soon as market conditions permit. The safety holdings are a core part of Skyler's Strategy.

Conclusion

Whether you're a current retiree or someone still in the process of saving for retirement, I hope that you found this article helpful. Be sure to read through other portfolio management and asset allocation articles to glean different perspectives, and please take the time to discuss your financial requirements and goals with your loved ones.

While I'm not retired yet, the strategy I laid out is how I would most likely manage my own retirement portfolio. Of course, this strategy may not be for everyone. Let me know in the comments section if you believe my suggestions provide an appropriate balance between current security and longer-term wealth preservation. I'd love to hear other ideas about retirement portfolio asset allocation. And as always, please do speak up if, like Grumpyoldcoot, you'd like me to see me write articles about any other specific topics.

For more ideas on retirement investing, check out my Editors' Pick article The Art Of Finding Rock Solid Retirement Stocks.

Disclosure: I am long PG, VNQ.

Disclaimer: I am an individual investor, not a licensed investment advisor or broker dealer. Investors are cautioned to perform their own due diligence. All information contained within this report is presented as-is and has been derived from public sources & management. Always contact a financial professional before making any major financial decisions. All investments have an inherent degree of risk. The future is uncertain, and actual results may be materially different from those expected. Past performance is no guarantee of future results. All views expressed herein are my own, and cannot be interpreted as the views of my employer(s) or any organizations I am affiliated with. Presentation of information does not necessarily constitute a recommendation to buy or sell. Never make any investment without conducting your own research and reading multiple points of view.