How much you can afford to spend in retirement (or leave to your heirs) is a function of how much assets you possess. Generally, the more assets you have, the more you can afford to spend. Most retirees need to invest (grow) their assets in order to maintain or increase their desired standard of living in retirement. At the same time, however, retirees need to protect their assets and watch their spending to ensure that:
- sufficient amounts remain throughout the entire period of their retirement to fund at least a minimum (essential) standard of living, and
- other spending goals are achieved.
As discussed frequently in our website, finding the right balance between growing, protecting and spending one’s assets depends on how willing a retired household is to risk their current standard of living for the possibility of attaining a higher standard of living. We believe that determining the appropriate allocation between investing in risky assets vs. non-risky assets is one of the most important financial decisions a household can make in or near retirement, but frequently insufficient thought is given to this decision. More often than not some sort of general rule of thumb is applied to household investments in stocks and bonds with or without the advice of a financial advisor.
The graphic below conceptually illustrates the importance of balancing growing, protecting and carefully spending one’s assets in meeting retirement objectives.
Asset Management--Keys to a Financially Successful Retirement
Here at How Much Can I Afford to Spend in Retirement, we encourage retirees to consider establishing two separate investment buckets to fund their total spending in retirement:
- A Floor Portfolio comprised of relatively safe (non-risky) investments and assets used primarily to fund Essential Expenses, and
- An Upside Portfolio comprised of more risky investments used primarily to fund Discretionary Expenses.
This liability-driven investment (LDI) strategy attempts to match relatively safe household assets with more critical household spending liabilities for the purpose of protecting the assets that fund essential expenses, while using an Upside Portfolio to grow assets that may be used to fund more discretionary expenses. This risk mitigation strategy has been variously described in personal finance literature as:
- a Safety-First approach,
- immunization of essential expenses, or
- funding needs vs. funding wants.
In our opinion, if you are not using a similar approach, you may be assuming too much (or too little) risk in your personal retirement plan. After a few words below about investing in the current economic environment, we will provide a simple example of how you can use our new Actuarial Financial Planner (AFP) to help you better allocate your assets in retirement between risky and non-risky investments in addition to measuring the overall sustainability of your spending plan.
Investing in the Current Economic Environment
As we write this blog, the Schiller (adjusted S&P 500 Price to Earnings) PE Ratio is 39.67, or only about 10% lower than the maximum historical Schiller PE ratio achieved in December, 1999 of 44.19 and 134% above the historical mean for this ratio of 16.89. All things being equal, the current very-high PE ratio portends reduced future stock returns relative to historical performance (and/or declines) in current stock market prices. Based on this ratio, one could certainly argue that the risk of investing in stocks at this time may not produce the additional expected rewards that may be expected based on historical returns. On the other hand, current expected returns on non-risky investments like bonds are also quite low. In addition, inflation appears to be emerging as a significant risk that can be difficult to mitigate. These and other factors may make the current economic environment more difficult for retirees to manage their assets to achieve a successful retirement than in prior years.
As we indicated in our post of November 13, 2021, it may make sense at this time to invest in life annuities rather than bonds to protect household assets. And while we are not investment advisors and will certainly not push you to buy an annuity, we, like many others who ponder “the annuity puzzle”, wonder why annuities have such a bad reputation with the general public. Very few of us have similar issues when it comes to buying other types of insurance to protect our assets, such as health insurance, home insurance, flood insurance, life insurance, etc. Fixed life annuities can be viewed as just another form of insurance that protects against longevity and investment risks.
Example
Don (age 65) and Mary (age 60) are renters who are considering retirement. In addition to their estimated Social Security benefits, they have accumulated savings of $500,000 invested 50% in equities and 50% in bond funds. As discussed in our post of November 13, 2021, they consider the $250,000 they have invested in bond funds to be 25% risky so they input an upside percentage for their total accumulated savings of 62.5% (0.5 X 100% + 0.5 X 25%). They estimate their annual recurring expenses in retirement, including taxes, will be $45,000. Don estimates that about 2/3rds of their annual expenses ($30,000) are essential and the rest ($15,000) are discretionary and can be reduced if necessary. The screen shot below shows the amounts they inputted, the default assumptions and the results from the AFP for retired couples. To significantly simplify the example, we have assumed no non-recurring expenses and no other sources of income.
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The results show a small but positive Rainy-Day Fund balancing item and Floor Portfolio assets that exceed the Couple’s present value of estimated essential expenses. Don is pleased with this result and shows the workbook to Mary in the hope that perhaps she will be convinced that now is a good time to retire.
Mary reviews the workbook and is ok with all of the amounts that Don has input except for Don’s estimate of their essential recurring expenses in retirement. She believes that all of their estimated annual expenses of $45,000 are essential, and she can’t imagine reducing that amount if there were a stock market crash similar to what happened in 2008/2009. Therefore, Mary enters $45,000 for annual recurring essential expenses and here are the revised results:
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By making this one change, Don and Mary’s Rainy-Day fund is now significantly negative and their Floor Portfolio assets are approximately $438,000 less than the estimated present value of their future essential expenses. They could move all of their risky stock investments to safer life annuities or bonds to cover part of this shortfall, but they want to maintain a significant level of investment in equities in order to:
- grow their assets,
- fund discretionary expenses like travel, and
- hedge against unexpected events such as increased medical needs, higher than expected inflation or future decreases in their Social Security benefits.
Don and Mary agree to postpone their retirements in order to build up more of a Rainy-Day Fund, adequately fund their Floor Portfolio and still maintain significant levels of investment in equities.
Summary
A good financial plan
should address how to balance the need to grow, protect and carefully
spend your assets in order to meet your financial goals in retirement.
In today’s economic environment, this may not be an easy proposition. We
believe our AFP can help you perform this balancing act.
