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 |
| 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.
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.
