Ah, retirement. Lots of newfound time to stop and smell the roses, play a little golf, take long walks on moonlit beaches, and sell off all those volatile stock holdings in favor of bonds and CDs, just as those Wall Street guys have advised for decades. Right?
Well, no, not exactly.
That advice isn't completely ridiculous; it's just outdated. The idea that retirees should only hold income investments wasn't necessarily a bad one in an era where people only lived for a few years after retiring. The thing is, these days, retirement can last for 20 or 30 years -- or longer. And even if your retirement nest egg is large enough to pay you a comfortable income today, inflation might make that same income look mighty uncomfortable in 10 or 20 years.
Even low inflation is still inflation
We've had an extraordinary run of low inflation rates for many years in the U.S., but even so, you'd need almost $1,800 to buy now what $1,000 bought you in 1987. Your comfortable income could end up losing half of its buying power before you're done with it. And leaving the principal alone is a great strategy for your heirs, but what if you need some of that money? Or what if your nest egg is in an IRA or other tax-advantaged plan that requires you to take taxable distributions every year?
Clearly, a different approach is needed. Income alone isn't going to do the trick for most Fools. You'll need some growth, you'll need to manage the overall risk of the portfolio sensibly, and you'll need a plan for taking those distributions -- and it needs to be simple, so that you can stick with it and have plenty of time to enjoy retirement.
Enter asset allocation
As you may already know, asset allocation is a way of reducing the overall risk of a portfolio by allocating your assets (get it?) among several asset classes -- in our case, stocks, bonds, and cash. The theory here is that the different asset classes move up and down in different ways. For instance, the stock market has performed well recently, but interest rates have been low. If interest rates were to rise, the stock market might languish, but cash investments would pay a higher rate of interest. By allocating a percentage of a portfolio to each of these asset classes, we get the kind of exposure we need to generate both growth and income while giving ourselves something of a cushion against market difficulties.
Seems obvious now, doesn't it? Let's look at how to put it into practice:
- Decide how much you want to withdraw every year, in today's dollars. (This is a complicated question, one that will take a considerable amount of thought. As a starting point, note that a number of academic studies have shown that the optimal amount to withdraw yearly -- the largest amount most people can take without running out of money early -- is around 4% to 5%.)
- Put one year's worth of withdrawals into a money market fund. That way, the next year's money is always completely safe.
- Next, take an amount equal to four to five years' worth of withdrawals and invest that in a high-quality bond mutual fund.
- Everything else? Buy stocks. Not just big-dividend payers like Pfizer
(NYSE:PFE)or General Electric (NYSE:GE), but a full range of stocks that includes exposure to other types of companies, such as international stocks and small caps. You can invest in stocks directly or via mutual funds, but over time, the stock market's return is what will keep your portfolio ahead of inflation.
Maintaining this strategy is also pretty simple, with an optional twist. Take withdrawals from the money market fund as needed. Once a year, rebalance the portfolio by selling investments that have appreciated and reinvesting the proceeds to get back to your original asset allocation mix, with another year's worth of cash in the money market fund.
Here's the optional twist: you can replenish the money market fund by taking money out of the bond fund in some years, without selling stocks. You may choose to do this during a bear market (when most stocks are temporarily down), or if you are fully invested in stocks that haven't yet realized the value you expect them to realize. While trying to time the absolute peaks of the market is unrealistic, having the flexibility to sell when prices are strong and to sit tight when they're not can give you an additional inflation-beating advantage.
In the end, aside from the provisions for planned withdrawals, this isn't really any different from any other Foolish strategy -- choosing good investments appropriate to one's goals, risk tolerance, and time horizon. Following this approach will give you some insulation against stock market volatility and some flexibility around market cycles, and you'll make sure that your near-term needs will be met -- while still leaving plenty of time for golf and roses.
Investing the right way is essential for the success of your retirement plan. For advice on how to put together the best retirement plan for you, take a 30-day free trial of the Fool's Rule Your Retirement newsletter. You'll find simple directions that will get you on your way to a successful retirement.
Fool contributor John Rosevear likes moonlit beaches but tends to sneeze when he stops to smell the roses. He does not own any of the stocks mentioned in this article. The Motley Fool's disclosure policy is comfortable in jeans but loves to dress up for a night on the town.