As a retiree, 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. (For more on such investments, visit our Savings Center.)

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 years 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 year's. 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
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
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.

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.