A Workshop Retirement Portfolio [Workshop] June 22, 2000

Workshop Portfolio A Workshop Retirement Portfolio

By Moe Chernick
June 22, 2000

Most Workshop strategies are fairly aggressive. They tend to illustrate the conventional wisdom that high returns entail higher risk (risk being defined as volatility of returns). But those high returns look really good. So one frequent question on the Workshop message boards is how suitable are Workshop strategies for those who are in retirement or nearing retirement.

Most have heard the conventional wisdom that your retirement money should be mostly in bonds and cash with maybe some money in conservative stocks. Even The Motley Fool's Retiree Portfolios are a combination of the Foolish Four and bonds, which is far too conservative in my opinion. Especially for today's retirees, many of whom are looking to finance a very active, upscale, and long retirement. To do that, most people need growth.

Of course, you also need safety. It's not easy to rebuild a trashed portfolio when you no longer have a paycheck coming in.

For retirees who are comfortable with allocating a substantial portion of their retirement funds to stocks, the kind of numerical discipline that the Workshop fosters can help a retiree increase his or her portfolio value while providing an increasing monthly income.

These strategies are somewhat different from many retirement strategies that tend to focus on making sure your money "lasts as long as you do." Such traditional strategies have a declining balance, which can be uncomfortable if you plan to live a long time.

Both of the strategies below focus on maintaining an income from a sustainable portfolio, i.e., one that grows over time rather than declining since that's the only way to be certain that your money will last as long as you live. We plan for a portfolio that won't go bust in bad times. In normal or good times, such a stock portfolio should grow rapidly and the monthly draw will increase year after year. The first example comes from Robert Sheard, one of the founders of the Workshop.

Robert Sheard suggests that as long as you can live on 5% of your retirement savings, there is no reason not to stay fully invested in the stock market. He states that under such a scenario, each January you would take out 5% of your savings for living expenses. The rest should stay fully invested in the stock market. Each January you simply follow the same strategy. If the market goes up you get more money, if it goes down you get less money.

He cites data showing that even if you invested in the market at the worst possible time since 1950 -- that is, right at the beginning of the 1973 market decline -- an annual payout of 5% would have been sustainable given a return equal to that of the High Yield 10. He does warn that you should make sure that 5% of your retirement savings will give you a sufficient retirement income before pursuing such a strategy. And there is a certain amount of risk involved in that if you did hit a bad stretch early in your retirement, your annual 5% withdrawals could be considerably less than you expect.

(Another study has shown that even starting in 1973, it would have been possible to maintain the original payout amount -- 5% of the starting value -- even during the time the portfolio was below its starting value. This would also have been a sustainable strategy given a return equal to the S&P 500, even though the S&P return was lower than the High Yield 10 during that time period. Under this scenario, though, the portfolio would not have recovered its original value for 24 years. That's too close for comfort.)

To pursue Sheard's original strategy, you have to live with possibly big year-to-year changes in your income. To minimize this problem, a Mechanical Investing board contributor, Galeno, shared with the board his retirement strategy. Galeno's strategy assumes a 4% withdrawal rate. He keeps five years' worth of income in a money market fund (MMF) with the remainder of his portfolio in stocks. Quite Foolish, actually, and a much safer strategy with a more consistent payout. It automatically gives the market time to recover from a bad spell. Here is his procedure, modified slightly for clarity:

  1. Divide the portfolio value by 360 to determine the starting monthly draw (or multiply your annual draw by 30 to get your starting portfolio value).

  2. Start with 60 months of living expenses in a MMF (monthly draw times 60) and the balance in stocks.

  3. Every January, sell 4% of the stock portfolio value and add the proceeds to the MMF.

  4. Divide the new MMF sum by 60 for your new monthly draw
For example if you want to retire with a monthly investment income of $1,000, you would need a portfolio of $360,000 ($360,000/360 = $1,000). You put five years' worth of expenses ($60,000) into a money market fund and the rest ($300,000) in stocks. For the first year, you draw $1,000 per month for living expenses. At the beginning of the next year, you sell 4% of your portfolio and add that to the MMF. Divide your MMF by 60 to get your monthly draw for the year. As long as your portfolio appreciates more than 4% for the year, your monthly income will increase each year. Galeno doesn't say what he would do if his portfolio decreases, but it seems to be implied that his monthly draw won't need to be decreased unless the portfolio fails to appreciate more than 4% per year over a five-year period.

What makes Galeno's strategy interesting is that he always has five years of savings in cash. Each month he draws 1/60th of his cash. This gives him a predictable income unthreatened by short-term market fluctuations. Even if the market has a bad year or two, the cash for living expenses is safe, and his portfolio has five years to recover.

This method allows a much more consistent income than Sheard's original method, but it is also more conservative. Since a smaller percentage is withdrawn each year, you will need a larger initial portfolio to provide the same initial monthly income as Sheard's. In good times, the stock portion of Galeno's portfolio will appreciate more rapidly under this method than Sheard's but won't provide as big an income boost. In bad times it will be less vulnerable and the income will be more consistent.

Should you be using either of these methods? Probably not. Your situation is unique, and there are many ways to finance your retirement. But these ideas can serve as a basis for designing your own well-thought-out plan. Try it and spend a few hours testing how it would work under various scenarios. Playing around with some variations on these plans could help you design a very comfortable and safe retirement plan that works for you.

Until next time, Fool on!