How Should Retirees Think About Their "Income Cushion"?

Regular listeners of the Motley Fool Answers podcast will know that Alison Southwick and Robert Brokamp are full of excellent investing and personal finance advice. But for this episode -- which they are dedicating totally to listener questions -- they've called in reinforcements: Ross Anderson, a certified financial planner from Motley Fool Wealth Management, a sister company of The Motley Fool.

In this segment, they respond to a soon-to-retire listener who's curious about asset allocation. He knows he needs a certain piece of his portfolio in nice, safe bonds, but he also wants to keep what the Fool calls an "income cushion." To what degree should those pots of money be the same? Anderson weighs in.

A full transcript follows the video.

This video was recorded on Feb. 27, 2018.

Alison Southwick: The next question comes from Alan. "Tomorrow I turn 64 years old." Hey, happy belated birthday, Alan! "And plan on retiring in one year." Good for you. "I am very excited." I'm excited for you. "We are selling our house and moving to the Florida Panhandle." Which is so beautiful.

Robert Brokamp: It is, depending on where you are, but, yes...

Southwick: Oh, places like Destin. The water. Oh, my goodness. So lovely. I don't know why they call it... No, I do know why they call it the "Redneck Riviera," but it is so beautiful. And that's no commentary about you, Alan. Whatever. Let's keep moving on.

"My question is about the bond allocation in the Rule Your Retirement model portfolio for retirees." Hey, another bond-related question.

Brokamp: What do you know?

Southwick: "Is this where I should keep three years' worth of living expenses, or should that be separate from the portfolio?"

Brokamp: Well, Alan, first of all congratulations, and as someone who grew up in Florida, I do think it's a lovely place to retire. The retiree portfolio in the Rule Your Retirement service is pretty standard -- 60% stocks, 40% bonds -- but I really like to think of it as 60% in the stock market and 40% out. And what you do with that 40% depends on when you're going to need the money, and that is where you would put that three-to-five years' worth of expenses that you'll need.

In Rule Your Retirement we call it the "income cushion." You just estimate how much you're going to need over the next three to five years, subtract Social Security, subtract anything you get from a pension, anything you get from an annuity, and then that remaining amount you put in cash, CDs, short-term bonds, maybe individual Treasuries. And the rest you can put in the stock market if you are aggressive enough but, generally speaking, about 60% in stocks, 40% is good. That income cushion is part of that 40%.

Southwick: And then every year I assume you have to feed that income cushion.

Brokamp: Exactly. Every year you have to replenish it. The original concept, or at least the term "income cushion" came from a guy named Dave Braze who used to write the Retiree Portfolio for The Motley Fool back in the early 2000s. And according to his methodology, you would replenish it every year, except in years where the stock market is down, and then you don't replenish it, because you don't want to sell your stocks while you're down. You just live off the income cushion until stocks recover.

Of course, that might take a while. Historically it takes three to five years for a bear market to get back to where it was. Sometimes, though, historically it's taken six to eight years, so you could run through that income cushion. At some point you have to sell, but generally live off the income cushion. Hold back on your expenses, if you can, and then replenish it when the market is back up.