Getting your portfolio ready for income
Just like you have to get yourself ready for retirement, you have to get your portfolio ready for retirement too. In most cases, this means getting your portfolio ready for income by making sure you have appropriate investments inside the portfolio.
The best time to retire
I’ve always said the best time to retire was back in 1981. Why? If you retired then, you could head to the bank and invest all of your retirement savings into a good old fashioned GIC at 12% to 19% guaranteed with no risk. At those interest rates, you could live off the interest and your capital would be guaranteed. You would never have to look at a statement and see negative returns. Ahhh . . . the good ole days!
Unfortunately, those days are long gone and today with really low single digit returns, most retirees can’t imagine living off the 1% to 3% returns that GICs are offering today.
As a result, most retirees are faced with diversified portfolios of different types of investments like mutual funds, stocks, managed portfolios and other non-guaranteed investments. As many of you know, these investments have created a different set of problems. I’ve talked to so many people in the last 10 years who delayed retirement because their portfolio dropped 20% to 30% months before their retirement date? And then there’s others who retired but then had to go back to work or stop their income because their portfolios dropped suddenly after they retired?
With low guaranteed returns retirees have more money invested in investments that provide variable returns. I’ve talked to many retirees who feel retirees are damned if you do and damned if you don’t. So how do retirees get their portfolios ready for retirement?
Variable return problems
Too much money in fluctuating investments can result in a deterioration in the longevity of your assets. In other words, too much risk while you are withdrawing money can result in running out of money a lot faster. This concept was covered in an article I wrote on how Variable Returns can work against you in retirement
A simple solution
One of the simple solutions to getting your portfolio ready for income and therefore ready for retirement is to make sure you have a portion of the portfolio invested in safe, conservative, low risk investments that can pay you and income for a pre-determined period of time.
My unsophisticated rule is to use the Rule of 5. Here’s an example to illustrate how it works.
Peter is 65 years of age and has a few minor health issues. He has a pension, took early CPP and is now has just started collecting OAS. He has $100,000 in RRSPs he would like to use over the next 10 to 12 years. As a result, he plans to take out $9000 per year until the money runs out. His financial advisor told him that was an aggressive withdrawal rate.
If the advisor leaves the money invested in a balanced diversified portfolio, there is a risk that systematic withdrawals can create bad timing risk. In other words, Peter could run out of money faster if he continues to take out money after a significant drop in the portfolio.
The rule of 5
To get the portfolio ready for this aggressive income, my rule of 5 suggests that he should take the annual income desired from the portfolio ($9000) and multiply by 5. That comes out to $45,000, which is the amount of money in the portfolio that should be invested in safe conservative investments. The rest of the money can be invested in higher risk investments to try to earn a higher rate of return.
Related article: A simple guide on guaranteed investing
The rationale behind the rule of 5 is that keeping $45,000 in safe investments, guarantees Peter 5 years of income. Even if the $55,000 drops in value, he will not have to withdraw that money because he has set aside enough money to guarantee himself 5 years of $9000.
Why 5 years?
It’s simply because markets will usually bounce back after corrections within a 5 year period. If you happen to be more pessimistic, then you can increase the number from 5 to 6, 7 or 8 years.
This strategy is an adaptation of the bucket strategy. In this example, there’s two buckets. One with $45,000 that will specifically pay income for 5 years. The second bucket has $55,000 invested with some growth in mind. The buckets have to be monitored regularly. The goals is to fill the second bucket by growing the investments. As this second bucket grows, it can be used to fill up the first bucket.
Related article: Creating income with the bucket strategy
There may be times when the second bucket is not filling up (investments are not doing well), there should be enough money in the first bucket to pay income.
Getting your portfolio ready for income is an important step in retirement planning. My rule of 5 is just a simple strategy to help answer the question “How much money should be invested conservatively?” What do you think of this strategy? Do you have any other ideas or suggestions on how to get a portfolio ready for income?