Keeping the Cash Flowing in Retirement

May 12, 2002

By JONATHAN CLEMENTS
Staff Reporter of THE WALL STREET JOURNAL

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 headaches."

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.

Help Is a Click Away

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 a problem.

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 deposit.

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 investments.

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 market.

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 month.

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."