UPTHINKING FINANCE

• The variables that impact preparation for retirement [1:00]
• Dividends and capital spend-down plans [1:52] 
• What is sequence of returns risk? [4:13] 
• A series of 20-year returns from 1989–2008 [5:04]
• How to preserve against varying returns [8:41]
• Properly positioning yourself in retirement [16:39] 

Let’s say someone’s goal is to withdraw $10,000 a month to cover their expenses in retirement. How do we help them work toward that goal? First, we add up fixed income sources such as social security, pensions, or rental income. Let’s say these total $5,000 a month. What’s next? There are two ways to approach supplementing that additional income. 

The first is through dividends. You can build a portfolio around investments that generate a monthly or quarterly distribution check, such as a municipal bond portfolio. If we need another $5,000 a month, the portfolio needs to generate $60,000 a year in dividend income.

The second strategy is a capital spend-down plan. We systematically sell shares or principal from the portfolio and it eventually depletes to zero. This is the route that most people take. Very few clients can rely on fixed income and dividends alone. If you draw 4% of your portfolio, you should be able to average a 4% gain and offset your spending. But this comes with risk. 

What kind of returns is the market providing as we’re liquidating a portfolio? We might have a general idea of what the market will do, but we can’t predict it, right? The variance compression principle states that the longer you go into an investment cycle the less variable the returns will be year to year. The reality is that it’s unpredictable. If we don’t plan for sequence of returns risk, it will derail your retirement. 

In this episode, I’m looking at a series of 20-year returns from 1989 to 2008. We’ve also inverted the order of the returns to start in 2008. Why’d we invert it? The market was up 31.69% in 1989. But when you invert the returns, we see that 2008 was down 37%. This will show us how a retirement portfolio fares starting with a bad year or a good year. 

Let’s say we start with $1 million, are invested in the S&P 500, and draw out $50,000 a year (including the 3% annual inflation adjustment). After 1989, the portfolio’s ending balance was $1,266,900. But when we look at the returns starting in 2008, the portfolio was down to $580,000. That account lost half its value between the market and the drawdown in the first year. 

Making that up would require the portfolio to have a 100% gain. That’s not only near impossible but it’s incredibly risky to attempt achieving. Eventually, after 18 years, the inverted portfolio ran out of money. The portfolio that started up 31.69% in 1989 ended its twenty-year run at $3,073,031.00. 

How do we ensure that we’re not selling assets into a down market? By using income segmentation also referred to as the bucket strategy. In this example, the buckets/segments start in three-year increments (I prefer to use five-year increments). How do we position money so that our retiree has $5,000 of supplemental monthly income? 

We want to place those funds in assets that will at least retain their value and will hopefully grow. This first five-year phase is the transition to retirement. If you’re in your 30s-40s, you’re investing for growth. A 10-year falloff in the market doesn’t matter. But it matters when you retire. So we invest this first bucket in a low-risk environment. 

Bucket two can include more risk, such as fixed-index annuities or balance funds. Then, once we get beyond the first 10 years, we focus on growth investments like blue-chip stocks that pay a dividend and things like small caps. Each segment becomes more aggressive. Why? Conservative investing can’t keep up with inflation. Retired people still need their portfolios to grow. It’s all about avoiding selling assets into a down market.

That’s the science—but it’s also an art. When clients are building a portfolio you’re setting goals and targets but retirement still feels like it’s in the distant future. Once you retire, the annual meetings become more critical. Managing these segments is a lot of work when done properly. But the strategy works well for most people. What can you do to properly position yourself in retirement? I share some strategies in this episode.