Investing During Retirement
For most of us, the likelihood of enjoying our preferred life-style during retirement is heavily dependent on steps we take years before we move into that season of life. The following three financial steps are among the most important you can take before reaching retirement to help guarantee that your retirement life-style will meet your expectations.
1. Be completely debt-free at your target retirement age. This includes your home mortgage and any college debt you may have incurred for your children. Debt, especially a high mortgage payment, limits investment options and life-style flexibility. If you need to add additional principle to today's monthly mortgage payment to pay it off by retirement, do it!
2. Maximize your contributions to your company's retirement plan, such as a 401(k). Hopefully you realize that Social Security will not meet 100% of your retirement needs. Public policy continues to move towards individuals becoming increasingly more responsible for funding their own retirement. The tax-deferred investment growth and savings discipline that occurs inside your company's retirement plan is hard to beat. Contributing to an IRA is also a good idea, especially if you're already taking full advantage of any matching within your company retirement plan.
3. Establish a savings/emergency fund. In other words, build your personal liquidity. Why is this important? First, it buys you time. Personal savings will allow you to postpone tapping into your retirement savings for monthly living expenses after the paychecks stop coming in. You will have adequate time to reposition your retirement investment assets, if necessary, and let them continue to grow tax-free. Second, it provides efficiency. If you need $20,000 for a new car, you won't have to take $30,000 out of your retirement funds, pay $10,000 in income taxes, and then have $20,000 left to spend for a car. Again, this allows your long-term investments to continue growing tax-deferred.
HOW DO I INVEST DURING RETIREMENT?
"How am I going to replace that monthly paycheck?" is frequently the first question a newly-retired person has. But, is it the right question to ask first? We believe it's merely one of a series of questions that, correctly answered, lead to good investment decisions. Instead of focusing immediately on income, a more appropriate starting point is determining which is a greater concern to you — the short-term risk of market volatility and potentially losing principal in the short run, or losing purchasing power to inflation over your retirement lifetime?
If you're uncomfortable with the idea of ever losing any money, then fixed-income investments (e.g., bank certificates of deposits, money market funds, Treasury bills and notes, short-term bonds) are the most appropriate investment vehicles for you. However, people are retiring earlier and living longer, and all but the very wealthy need to continue to invest some money in stocks in order to keep up with inflation. For the non-stock portion of your portfolio though, the following are some simple strategies to increase income and avoid capital risk:
1. Use a money market fund rather than a bank money market account. For readily available money to pay living expenses, with no possible loss of principal, use a money market fund. They almost always pay a higher rate of interest than the savings accounts offered at your local bank. A list of the better paying money market funds is available in our Best Rates tables 
.
2. Shop nationally to obtain the highest CD rates. Banks vary widely in the interest rates they pay on CDs. A quick check recently revealed that some of our local banks were paying nearly 1.5% less on a one-year CD than the leading banks nationally. The monthly Best Rates tables are a good place to start your search. Once you purchase your CD, be prepared to shop around again when it matures; another bank may offer better rates next time.
3. Build a savings "ladder." Longer-term CDs pay higher rates than short-term ones. A good way to obtain the higher rate without sacrificing your liquidity is to build a portfolio of CDs with staggered maturities. This would mean investing in CDs which mature in six months, one year, eighteen months, and so on. If you wish, you can extend out as long as five years to get the very highest rate. As each CD matures, roll it over to the most distant maturity.
4. Buy intermediate-term bonds. A five-year corporate bond may pay you 1%-2% more than a comparable five-year CD. The drawback is that bond values go up and down as interest rates change (as rates rise, bond prices fall, and vice versa). As long as you don't sell your bond before it matures, you avoid the risk of loss. In order to hold your bonds to maturity, take your liquidity needs into account. Shop around when purchasing bonds, checking with your local bank as well as the major discount brokerage firms like Fidelity, TD Waterhouse, and Schwab.
5. For diversification, consider a no-load bond fund. Bond funds buy multiple issues of different types of bonds. Their portfolios can be short-term, intermediate-term, or long-term, and vary in the quality of their holdings. With interest rates at least reasonably likely to rise over the next few years, SMI is currently recommending short-term bond funds for most investors, with possibly some intermediate-term bonds for those with a high percentage of their portfolio invested in bonds. (See Preparing for a Positive 2005 for SMI's 2005 allocation suggestions. Also see Update On Vanguard Income-Oriented Portfolios for an alternate approach to constructing a Vanguard bond portfolio.)
One drawback of investing through a bond fund is that it never reaches maturity. This means you can't avoid a potential loss of principal simply by holding the fund long enough. As a result, you need to be prepared to see some fluctuations in principal value. Vanguard is usually the best choice for investors who plan to do considerable bond fund investing.
6. Consider the tax consequences. The interest earned on municipal bonds is exempt from federal income taxes. Municipal bonds issued in your state can also save you money on state income taxes. You can invest in them directly, or through tax-free money market and bond funds. Because they're tax-exempt they don't pay as high an interest rate, but it's the after-tax income that counts. To determine if taxable or tax-free bonds would be more appropriate for your tax situation, see The SMI Handbook, p159-160.
TAKING A "TOTAL RETURN" APPROACH
A retired investor has to weigh the importance of two competing desires. One is the desire to minimize portfolio volatility and not lose money, even over short time periods. If this is a major priority and you have a sufficiently large retirement nest egg, you can stick with income-oriented strategies like those listed previously and enjoy very little short-term volatility.
But for many, the more pertinent concern is not running out of money during your (or your spouse's) lifetime. If you're not likely to retire with enough money to simply "live off the interest," this means constructing a retirement portfolio that will grow with inflation and protect your purchasing power and life-style. That means continuing to invest a significant portion of your portfolio in stocks. But aren't stocks risky? The traditional answer is "yes." Stocks generally are more volatile than bonds. But because of inflation, volatility isn't the whole picture on risk.
Over time, inflation causes a static amount of money to essentially become worth less — it erodes money's purchasing power. Purchasing power is also eroded when the cost of an item increases at a rate faster than inflation. For the past several years medical costs have been the best example of an expense category rising faster than inflation. The $50 office visit five years ago now costs $100+. Other categories such as housing, especially in some high growth geographic areas, have also risen much faster than inflation.
The solution then is to continue to invest part of your portfolio in stocks. But with stock dividends at such low levels, many retirees don't like that idea because stocks don't generate enough income. The ideal of "not touching the principal" and living off the interest of a portfolio can be difficult to shake. To get over this mental hurdle, we advise retirees to take a "total return" approach to their income needs. Purely from an income standpoint, would you rather own a bond that yields 5% or a combination stock/bond portfolio that yields 2%? The bond at 5% seems like the logical choice: earnings of 5% on $100,000 in bonds is $5,000 a year, while the 2% yield on the $100,000 stock/bond portfolio offers just $2,000 in income. But the amount of current income obtained from a particular investment shouldn't be the only thing considered in this decision.
Generally speaking, in three out of four years the total return (yield plus capital gains) from a stock portfolio will exceed the total return from an all-bond portfolio. What if, thanks to the stock holdings, the $100,000 stock/bond portfolio grew in value by 7% during the year? When you add the income of $2,000 to the appreciation of $7,000, the total return was $9,000 — considerably more than the return from the bonds. But what if you need the full $5,000 of income to help meet your living expenses? Simply withdraw the difference from the stock/bond portfolio, selling some stock or bond fund shares as needed.
The table below gives two ten-year scenarios. In each case, an annual withdrawal is made that is adjusted upward to keep pace with a 3% rate of inflation (e.g., if income of $5,000 was desired initially, then $5,150 would be needed at the end of Year 1 in order to maintain purchasing power).
The "fixed income" strategy relies exclusively on bonds and CDs. An average rate of return of 5% is assumed. Note that this strategy falls behind almost immediately. The first year's withdrawal, after adjusting for inflation, is more than the amount earned. A small dollar amount of securities must be sold in order to fund the full payout. This leaves less remaining to invest in Year 2, resulting in a slightly greater shortfall that year. More securities must be sold to fund the payout. The cycle continues, slowly eating into the principal. Furthermore, the "ending balance" column in Year 10 doesn't tell the full story. After adjusting for 3% annual inflation, the principal's purchasing power is shown to be reduced to an even greater extent (far right column).
Now let's look at the "total return" portfolio consisting of 60% stock funds and 40% bond funds. Returns vary from year to year, but assume they average 9% per year over the entire decade. The first year all goes well, but stocks take a hit in Year 2, pulling the entire portfolio down. Securities must be sold (in such a way as to maintain the 60%-to-40% balance going into Year 3) in order to fund the payout. Briefly, the portfolio is looking worse than the fixed income strategy. What does the retiree do when his stock-oriented portfolio loses money? The first thing to remember is that you are investing for the long-term. Over the long haul, periods of ten years and longer, stocks have consistently produced positive results. Given life expectancies today, most retirees will live for 20-35 years off their portfolios, so a long-term perspective is appropriate.
At the end of the ten years, the stock/bond portfolio is worth $148,820 compared to $90,961 for the fixed income strategy. More importantly, it has maintained its purchasing power — it's worth $110,736 in constant dollars. Even after adjusting for inflation, the account has 10.7% more purchasing power than it did when the strategy was launched. The important point to note is that the total return approach to investing still allows you to take a full annual withdrawal even in years when the market declined or did not return as much as the withdrawal rate. I used the 60/40 portfolio mix in the example because SMI recommends it for investors with five or less years until retirement (assuming one can emotionally accept the risk — see Table 1 on Upgrading: Easy as 1-2-3 , or for more detail, Jumpstart ).
GETTING A REGULAR INCOME FROM YOUR PORTFOLIO
Turning a portfolio of stocks and bonds into a stream of regular income can seem complicated. It doesn't need to be. It can be as simple as telling your brokerage to sell enough shares of a particular stock or bond fund every quarter to generate a specific income dollar amount. By rebalancing your portfolio every year or so, you can make sure that your stock/bond allocation stays on track despite the periodic withdrawals. While this approach is attractive in its simplicity — it runs on autopilot once set up — some investors prefer an approach that's more responsive to what's currently happening in the markets.
The ideal situation for a retiree generating income from a mixed stock/bond portfolio would be to sell stocks only at peaks in the stock market, thus getting absolute top dollar with every sale. Unfortunately, identifying the absolute high and low points of the stock market isn't realistic. It's simply too difficult to do. However, it is reasonable to recognize that along the market's long-term upward path, it takes many detours both up and down. This volatility presents an opportunity to the retiree who is prepared for it.
The way to approach this is to combine a good money market mutual fund with your stock/bond portfolio. By putting 3-5 years worth of living expenses (or more specifically, the portion of living expenses to be funded from investments) into the money market fund initially, the retiree doesn't need to sell any more long-term investments for income unless an attractive market opportunity presents itself. The amount in the MMF is allowed to fluctuate between $0 and the full three-five year amount, with it running lower during times of poor stock market performance (think 2001-2002), and filled up again when the market has been doing particularly well. Since the market tends to have significant peaks and valleys every 3-4 years on average, it would be rare that a retiree would ever need to sell when prices are poor.
So what exactly constitutes an attractive selling opportunity? Remember, we're not talking about calling the absolute market tops and bottoms. Let's think back over the past several years to see how this might work. As early as December 1996, Alan Greenspan made his "irrational exuberance" speech, warning that stock prices seemed too high. At that point, our retiree might have filled their MMF to the maximum level. As the market continued higher from 1997-1999, he could have periodically (every 6 or 12 months) continued to sell a little to keep the account full to the max. This would have caused the MMF to be nearly full when the bear market began in early 2000. Because all living expenses were accounted for in the MMF, the retiree wouldn't have felt any need to sell as prices fell in 2001 and 2002. Depending on the number of years stored up, the retiree might have started to sell a little again in 2003 as stock prices recovered, and by early 2004 would likely have started restocking the MMF in earnest again following gains of 30-40% the year before. You can see that without being precise at all about the turns in the market, you can still sell into strength and sit tight during weakness if your immediate living expenses are accounted for in the MMF. Of course, this idea only works if the total portfolio size is large enough that having 3-5 years worth of living expenses in cash isn't going to put too much of a drag on the total return of your portfolio.
RETIREES AND IRAS
Taxes may be the last thing on your mind as you approach retirement. After all, if anything your income will likely be lower than while you were working, right? Not necessarily. If you're retiring with significant assets in IRA's, or in company retirement plans that will be rolled over into IRA's upon retirement, the "required minimum distribution" rules that kick in at age 70½ can create surprising tax issues, often pushing retirees into higher tax brackets than they expect. But there are creative ways to prepare for this.
One such way is to take advantage of a key distinction between Traditional IRAs and Roth IRAs: with a Roth, there are no mandatory minimum distributions to be taken at any point. The trick then is to convert your Traditional (including rollover) IRAs into Roth IRAs. To do so, the idea of using a money market fund to stockpile several years worth of living expenses comes in handy again. This time, as you prepare to retire, you would load the MMF with enough money to cover all living expenses for several years. By not selling any investments these first few years of retirement, and ideally delaying the start of your Social Security payments, your taxable income should be extremely low. You can take advantage of this low income by converting large chunks of your Traditional IRA into a Roth. You'll have to pay income tax on the converted amounts, but you'll be paying tax at the lowest rates. Remember, this is tax you would otherwise have to pay later when withdrawing the funds from the Traditional IRA anyway, so you're not losing anything by paying it earlier.
What you gain is substantial. For starters, the money that is now in the Roth IRA will grow tax-free as opposed to merely tax-deferred. In addition, your required minimum distributions from any remaining Traditional IRAs will be much smaller when they eventually kick in, meaning lower tax and greater flexibility. And finally, if you've delayed receiving Social Security during this process, your monthly benefit will be larger. Naturally this process is going to require some planning and fine-tuning. For many people preparing to retire, paying a qualified CPA to help with some basic tax planning is money well spent.
SUMMARY
A financially secure retirement does not just happen. Like all worthy goals, it takes planning and managing. If you are not retired yet, a planning weekend to discuss what you would like your retirement to look like and what you need to do now to prepare for that kind of retirement life-style may be in order. If you are a few years into retirement, ask yourself, "What worries me most about my retirement situation?" If one of the concerns is losing purchasing power, begin to rethink your investment asset allocation decisions and, especially if you are in your late 50's or early 60's, think about making equities a significant portion of your retirement portfolio.
Everyone looks forward to retirement, but not everyone finds their expectations are met once they arrive there. That doesn't have to happen to you. If well planned for, on both a financial and personal/spiritual level, retirement can meet and even exceed your expectations. Proper planning and investing are an important part of making your retirement years golden. 
- Got a question or comment about this article? Discuss it on our Message Boards.
