Retirement Cash Flow Strategies
- Austin Pryor Sound Mind Investing
- 2006 16 Jun
Turning a portfolio of stocks and bonds into a stream of regular income can seem complicated. It doesn't need to be. It can be as simple as telling your brokerage to sell enough shares of a particular stock or bond fund every quarter to generate a specific income dollar amount. By rebalancing your portfolio every year or so, you can make sure that your stock/bond allocation stays on track despite the periodic withdrawals. While this approach is attractive in its simplicity -- it runs on autopilot once set up -- some investors prefer an approach that's more responsive to what's currently happening in the markets.
The ideal situation for a retiree generating income from a mixed stock/bond portfolio would be to sell stocks only at peaks in the stock market, thus getting absolute top dollar with every sale. Unfortunately, identifying the absolute high and low points of the stock market isn't realistic. It's simply too difficult to do. However, it is reasonable to recognize that along the market's long-term upward path, it takes many detours both up and down. This volatility presents an opportunity to the retiree who is prepared for it.
The way to approach this is to combine a good money market mutual fund (MMF) with your stock/bond portfolio. By putting 3-5 years worth of living expenses (or more specifically, the portion of living expenses to be funded from investments) into the money market fund initially, the retiree doesn't need to sell any more long-term investments for income unless an attractive market opportunity presents itself. The amount in the MMF is allowed to fluctuate between $0 and the full three-five year amount, with it running lower during times of poor stock market performance (think 2001-2002), and filled up again when the market has been doing particularly well. Since the market tends to have significant peaks and valleys every 3-4 years on average, it would be rare that a retiree would ever need to sell when prices are poor.
So what exactly constitutes an attractive selling opportunity? Remember, we're not talking about calling the absolute market tops and bottoms. Let's think back over the past several years to see how this might work. As early as December 1996, Alan Greenspan made his "irrational exuberance" speech, warning that stock prices seemed too high. At that point, our retiree might have filled their MMF to the maximum level. As the market continued higher from 1997-1999, he could have periodically (every 6 or 12 months) continued to sell a little to keep the account full to the max. This would have caused the MMF to be nearly full when the bear market began in early 2000. Because all living expenses were accounted for in the MMF, the retiree wouldn't have felt any need to sell as prices fell in 2001 and 2002. Depending on the number of years stored up, the retiree might have started to sell a little again in 2003 as stock prices recovered, and by early 2004 would likely have started restocking the MMF in earnest again following gains of 30-40% the year before.
You can see that without being precise at all about the turns in the market, you can still sell into strength and sit tight during weakness if your immediate living expenses are accounted for in the MMF. Of course, this idea only works if the total portfolio size is large enough that having 3-5 years worth of living expenses in cash isn't going to put too much of a drag on the total return of your portfolio.
Retirees and IRAs
Taxes may be the last thing on your mind as you approach retirement. After all, if anything your income will likely be lower than while you were working, right? Not necessarily. If you're retiring with significant assets in IRA's, or in company retirement plans that will be rolled over into IRA's upon retirement, the "required minimum distribution" rules that kick in at age 701/2 can create surprising tax issues, often pushing retirees into higher tax brackets than they expect. But there are creative ways to prepare for this.
One such way is to take advantage of a key distinction between Traditional IRAs and Roth IRAs: with a Roth, there are no mandatory minimum distributions to be taken at any point. The trick then is to convert your Traditional (including rollover) IRAs into Roth IRAs. To do so, the idea of using a money market fund to stockpile several years worth of living expenses comes in handy again. This time, as you prepare to retire, you would load the MMF with enough money to cover all living expenses for several years. By not selling any investments these first few years of retirement, and ideally delaying the start of your Social Security payments, your taxable income should be extremely low. You can take advantage of this low income by converting large chunks of your Traditional IRA into a Roth. You'll have to pay income tax on the converted amounts, but you'll be paying tax at the lowest rates. Remember, this is tax you would otherwise have to pay later when withdrawing the funds from the Traditional IRA anyway, so you're not losing anything by paying it earlier.
What you gain is substantial. For starters, the money that is now in the Roth IRA will grow tax-free as opposed to merely tax-deferred. In addition, your required minimum distributions from any remaining Traditional IRAs will be much smaller when they eventually kick in, meaning lower tax and greater flexibility. And finally, if you've delayed receiving Social Security during this process, your monthly benefit will be larger. Naturally this process is going to require some planning and fine-tuning. For many people preparing to retire, paying a qualified CPA to help with some basic tax planning is money well spent.
A financially secure retirement does not just happen. Like all worthy goals, it takes planning and managing. If you are not retired yet, a planning weekend to discuss what you would like your retirement to look like and what you need to do now to prepare for that kind of retirement life-style may be in order. If you are a few years into retirement, ask yourself, "What worries me most about my retirement situation?" If one of the concerns is losing purchasing power, begin to rethink your investment asset allocation decisions and, especially if you are in your late 50's or early 60's, think about making equities a significant portion of your retirement portfolio.
Everyone looks forward to retirement, but not everyone finds their expectations are met once they arrive there. That doesn't have to happen to you. If well planned for, on both a financial and personal/spiritual level, retirement can meet and even exceed your expectations. Proper planning and investing are an important part of making your retirement years golden.
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