Fool.com: Creating a Comfy "Income Cushion" [Retiree Portfolios] April 17, 2000

Retiree Portfolio Creating a Comfy "Income Cushion"

By David Braze (TMF Pixy)
April 17, 2000

In last week's column I mentioned that I maintain a five-year cushion of income that is not invested in the stock market. Like many Fools, I do so because I know I will spend that money within the next five years, and I don't wish to sell stocks during a down market when I need that cash. Accordingly, I keep that five-year income cushion in things like money market funds, Treasury bills, certificates of deposit, and short- to mid-term bonds where it can still earn interest yet avoid most of the volatility found in the stock market. That concept gave rise to two questions from a number of readers: How do I determine the size of my five-year cushion and where specifically do I put the money?

There are a number of ways you can establish the size of your five-year pot. I simply start with the gross income I want for the first year. From that, I subtract my known income from pensions, wages, Social Security benefits, etc. That establishes the year's shortfall that must come from investments. Then, using an assumed inflation rate, I simply inflate that estimate to determine my shortfall for each of the next four years. Let's look at a hypothetical example to see what I mean.

Say I desire $35,000 in pretax income for my first year in retirement. $18,000 of that income will come from a company pension, $12,000 from Social Security, and the remaining $5,000 from investments. I expect inflation to average 3% annually over the next five years. My pension will not increase along with inflation, but my Social Security benefit will. Before I take my first year's income, my investment stash is $100,000. Given all that, I can construct the following table:

           Year 1  Year 2  Year 3  Year 4  Year 5
Income     35,000  36,050  37,132  38,245  39,393
Less:
 Pension   18,000  18,000  18,000  18,000  18,000
 Soc.Sec.  12,000  12,360  12,731  13,113  13,506
Shortfall   5,000   5,690   6,401   7,133   7,887
Note that I have inflated my desired income in the second and subsequent years by the assumed inflation rate. I did the same for my Social Security benefit, which has yet to be denied an inflationary increase by Congress. My five-year income cushion is simply the sum of the shortfalls for Year 1 through Year 5, or $32,110. I now subtract that amount from my initial retirement stash of $100,000, which leaves me with $67,890 to invest in stocks. From the $32,110 cushion, I take $5,000 (the current year's shortfall) and invest it in a money market fund until I withdraw it later in the year when I need it to meet living expenses. I invest the remaining $27,110 in short-term and intermediate-term bonds. In total, $95,000 remains invested with 71.5% in stocks and 28.5% in bonds. Does that sound anything like asset allocation to anyone?

At the end of Year 1, I note what happened. I see that my actual inflation rate was 2.5% for the year; that my stock portfolio earned 11% to end at $75,358; and that my bond portfolio earned 6.5% to end at $28,872. I increase my second year's desired income by 2.5% to keep pace with the actual inflation rate, and construct a new table for the next five years based on the new year's desired income. However, I keep future inflation constant at 3%. The new table looks as follows:
           Year 2  Year 3  Year 4  Year 5  Year 6
Income     35,875  36,951  38,060  39,202  40,378
Less:
 Pension   18,000  18,000  18,000  18,000  18,000
 Soc.Sec.  12,300  12,669  13,049  13,441  13,844
Shortfall   5,575   6,282   7,011   7,761   8,534
The new shortfall for all years shows my five-year income cushion should be $35,163. The cushion at the end of Year 1 is only $28,872, so I'm short $6,291, an amount I take from the stock portfolio. (Note: Had stocks been down for the year, I would not take anything from that portfolio. Instead, I would take only the $5,575 I need as income in Year 2, and that would come from the bond portfolio. I would then replenish the bonds in a later year when stocks were up again.) From the $6,291 taken from stocks, I then take $5,575 (my needed income for Year 2), and again put it in the money market fund. The remaining $716 is invested in bonds. When all is said and done, at the start of Year 2 I have $69,067 remaining in my stock portfolio and $29,588 in my bond portfolio, for a total of $97,608. Of that total, 70% is in stocks, and 30% in bonds, a slightly lower ratio of stocks to bonds than the year before.

The investment of your five-year income cushion can be in anything that meets your comfort level. I like to put the current year's income into a money market fund until it's needed, and then I split the remaining four years' income evenly between short-term and mid-term bonds. Some folks use a combination of Treasury bills, certificates of deposit, and a bond ladder. In a bond ladder, one-fourth of the bond portfolio in the previous examples would mature each year. That means I could then either reinvest that one-fourth of maturing bonds in a new issue at the going interest rate that would mature four years later, or I could use the proceeds for my following year's income needs. Regardless, and as you can readily see, there are many ways you can handle your investments. The one I use is simply the method that allows me to sleep comfortably at night.

So there you have it, one Fool's way of determining a five-year income cushion and investing same. It's not the only way or even -- except for me -- the best way. It's just one way of many. Your task, should you choose to accept it, is to find the way that works best for you.

See you next week. In the meantime, post away on the Retired Fools board.

Best to all... Pixy