These questions are more important than many retirees realize. Decisions about your principal—whether to tap it or preserve it for your heirs—have a say in how retirees invest their money, and as such, how much risk they need to take in later life. There can be a big difference.
I asked Charlie Farrell, a managing director in Denver with Beacon Point Advisors, if he could run some numbers and discuss what makes a sustainable portfolio in later life. Here are excerpts from our conversation:
WSJ: Are retirees today looking for or adopting a certain kind of portfolio?
Mr. Farrell: I think retirement is primarily about a more comfortable lifestyle in its various forms. As the risk of health challenges increases, and as we face the realities of reaching the end of our lives, most people would prefer more comfort or stability around their finances, if at all possible. In general, this means a portfolio with low volatility.
WSJ: How do you build a “comfortable” portfolio? And how does this relate to tapping or tapping one’s principal in retirement?
Mr. Farrell: The comfort you can find in a portfolio largely depends on two things: whether you’re spending less on principal, and whether you have control over what I’ll call your personal inflation rate. If you’re spending less on principal—in other words, you don’t have a specific goal of leaving an inheritance for children or a charity, and you just leave whatever’s left over—and if your at your own personal inflation rate. If you have control, you have far more flexibility to design a less-volatile portfolio.
WSJ: How do you determine your “personal inflation rate”? And how do you control it?
Mr. Farrell: You can add up everything you spend in one year and then add up everything you spend the next year and compare the numbers. But a more practical approach is to manage your money at the individual inflation rate that you choose. In other words, you spend within a specific budget and limit your personal rate to a certain percentage.
Let’s say inflation is running at 8% and you want to limit your inflation rate to 5%. In that case, you will spend no more than 5% of what you are spending on a monthly basis going forward. That way you’ll be forced to manage your money at that number, and make the cost and quality trade-offs necessary to hit that number.
WSJ: What are some of the agreements?
Mr. Farrell: Let’s say you spend $120,000 a year, but only $50,000 of that is on essentials for your home like utilities, health care, taxes, insurance, maintenance. The rest is discretionary: entertainment, travel, hobbies, etc. There isn’t much you can do about your car insurance. But you can make different choices around discretionary spending.
The point is to experiment with what you are doing and see if you can prevent inflation in retirement and still enjoy life. For example, you may want to buy an expensive car, but you decide to get a more modest model. If you can do that — if you can keep your personal inflation rate under control and perhaps even lower it — it lessens the pressure to increase annual withdrawals from your nest egg. And that means you need diminishing returns to sustain your savings for as long as you do.
Historically, the toughest cycles for retirees have been those with high inflation and falling or stagnant markets—basically, the ones we have today. If it only lasts a year or two, it’s not a big deal. But if it continues, it will be a big challenge.
WSJ: Let’s talk about returns. What kind of return would a couple need if they are willing to tap their principal versus a couple who want to preserve it?
Mr. Farrell: Let’s say you start with $1 million and withdraw 4%, or $40,000, a year and there is no inflation and no portfolio growth. The money will last for 25 years. So to reach 30 years, you only need a 1.5% return on your portfolio, if inflation is 0%. If you take inflation to 2%, you will see that to make it 30 years, you need a total return of about 3.5% (1.5% return plus 2% inflation rate). Take inflation to 3% and if your return is 4.5%, you can make 30 years, and so on.
So roughly 1.5% returns above inflation will get money for the last 30 years. Of course this is on paper, but it gives you a basic understanding of how much extra return you need. It’s not much, really, if you’re okay with spending the principal over time.
WSJ: And what about the couple who want to keep the principal safe?
Mr. Farrell: Here, you’ll need about 3% to 3.5% above inflation, with inflation in the 2% to 4% range. Let’s say your personal inflation rate is 2%. In that case, you’ll need a return of around 5% to 5.5%. While that doesn’t sound like much, you’d have to allocate a significant amount of shares to get this return.
If you assume a 3% bond return and a 6% stock return, you would need a little over 80% of your funds in stocks to hit a 5.5% portfolio return. But to get 3.5% return, you would need only 30% in stocks. Thus, the willingness to retain the principal makes a big difference in how much risk you can take.
WSJ: Sounds simple.
Mr. Farrell: Well, these are spreadsheet assumptions, and of course, the real world is much messier. Who knows what the return will be next. But if you need higher returns, you’ll need to hold more in equities, which increases volatility and uncertainty — and thus, generally increases discomfort.
So if you don’t take into account the potential for the principal to be consumed over time, and if you can get a handle on your personal inflation rate, you can be more conservative and, thus, more comfortable. It’s really about what things are most important to you.