Is there just one way for retirees to invest? Photo by Ian Taylor on Unsplash
I’m often asked this question: “Am I investing the right way?”
The answer is more straightforward for someone still saving for retirement. For a pre-retiree or retiree, it’s more complicated. A few points to note:
Investment needs, to a certain extent, are driven by retirement income needs
How and where to invest certain funds may change depending on the types of accounts you have (tax-deferred, taxable or tax-free).
Retirement income needs should consider future retirement spending on things like household expenses, taxes, Medicare costs, and charitable giving to name a few.
To the last point, these costs are difficult to predict, and for a 25-30 year retirement they’re nearly impossible, but building a plan you know will change is far better than no plan at all.
Specifically, estimating where these different costs will be allows us to back into a necessary income number. Once we know your required income, this can help you better determine the “right” investments.
Example: Mark and Karen are planning to retire next year. They’ve both worked as teachers in the Wyoming Retirement System for over 30 years. They anticipate expenses of $9,000/month, and they expect inflation to raise those costs by about 2.5% per year. When they retire, they will both have pensions and Social Security (both with a cost of living adjustment), which will produce $7,000/month of income. They have no other retirement assets other than a 457 account in Mark’s name with a balance of $500,000.
How should they invest this money? We can start figuring this out by dividing Mark’s income need by the portfolio total. $24,000/$500,000 is 4.8%. We would call this Mark’s annual withdrawal rate. Mark and Karen are planning to be retired for at least 25 years, so they want to be confident that their money won’t run out.
At this point it helps to use a financial tool to do some heavy lifting for us. I like Vanguard’s Retirement Nest Egg Tool. By inputting a 25 year retirement, $500,000 portfolio, and $24,000 required annual income ($2,000/month), we can then toggle the sliding bars to assemble a portfolio with a target “success rate” that the savings will last 25 years.
To be conservative, let’s target an 85% or higher success rate. Moving the bars to an investment allocation of 65% stocks, 25% bonds, and 10% cash yields a success rate of 86%.
So what’s the “right way” for Mark and Karen to invest? If they want at least an 85% chance that their investment funds will last 25 years, then a 65% stock, 25% bond, and 10% cash allocation should get them there. Of course there are no guarantees in this; all we can go on is the historical performance of a similar portfolio to help predict this outcome.
What if Mark and Karen’s income needs are $8,000/month? In this case, the income shortfall we need to make up from investments is only $1,000. This equates to an annual withdrawal rate of only 2.4% which coincidentally is close to their inflation expectations. This means the portfolio can be far more conservative, requiring a very modest investment return over time.
Running the same scenario, the calculator tells us that a very conservative portfolio of 30% stocks, 40% bonds, and 30% cash still carries a 99% chance of success.
The “right way” for Mark and Karen to invest in retirement has drastically changed based on their retirement income needs.
Clearly there are a multitude of variables in determining the right way to invest. Rather than making guesswork of your hard-earned investment portfolio, consider this summarized approach instead:
Estimate your expected retirement costs
Determine your different sources of fixed income (like Social Security or pensions), their amounts, and how a cost of living adjustment feature might help this income keep pace with inflation
If there is a shortfall, identify how much income is needed from your investments to make up the difference
Determine a target success rate (I’ve found 80% or higher to be reasonable)
Use a tool like Vanguard’s Retirement Nest Egg Tool to help you determine an appropriate investment allocation based on your number of years in retirement, nest egg amount, income needs, and success rate.
As you age throughout retirement, this approach can be re-run every five years or so. As you age, your investments can likely become more conservative over time since spending needs tend to decline, but this may not always be the case. Ultimately your income needs are driven by your anticipated expenses.
One final suggestion. When using a retirement tool, the recommended investment allocation may be far riskier than you’re comfortable with. If this is the case, you’ll need to either increase income from other sources, decrease spending in certain categories, or reduce your target success rate.
I hope this article has been helpful as you consider the “right way” to invest. There really is no universal right way! Rather, it’s a question of your expected income needs, which are driven by your spending. Start by asking the spending question, then the investment picture will become more clear.