08/10/05 - How to Prepare for Retirement
By: Frank Armstrong, CFP, AIF
How to Prepare for Retirement:
Transitioning from Accumulation to Distribution Phases
Investing during retirement is entirely different than investing for retirement. Different strategies are required for the accumulation and distribution phases.
During the accumulation phase it may be appropriate to take moderate risks in return for the prospects of higher returns. A young person with a very long time horizon until retirement and a high risk tolerance might invest her entire portfolio in stocks.
During retirement, a much more conservative portfolio is generally called for. That's because the requirement to generate periodic withdrawals to produce income introduces a risk that the portfolio might self-liquidate. Generally speaking, a retirement portfolio should be very heavily weighted in short-term bonds, which provide a store of value to fund needed distributions without interruption and to reduce the risk for the portfolio. Both are important to retirees.
A generous cushion of bonds provides a ready source of funds for distribution without regard to market fluctuations. We believe that retirees should determine their total income needs for the next seven to 10 years and allocate enough bonds to cover at least that amount. For instance, a retiree that expects to withdraw 4 percent of his nest egg each year would want to hold at least 28 percent to 40 percent in bonds. With that cushion established, the retiree can withdraw for a very long time without being forced to liquidate his more volatile stocks during a possible down market. It's important to preserve those volatile but high-return growth assets for future recovery.
A low-risk, low-volatility portfolio generally provides a higher probability of success during the withdrawal phase than a more volatile portfolio. Here we define success as not running out of money while alive. While bonds may not earn as much as stocks over the long run, they serve to greatly reduce the portfolio risk.
It would be a mistake to wait until the last possible moment to change strategies from accumulation to distribution. After all, you wouldn't want your retirement tomorrow dependent on what the market did today. If you are not properly positioned in advance, a couple of bad years in the market might set your retirement date back a decade or more. An orderly migration strategy from accumulation to distribution strategies insures that you won't be hung out to dry if the market turns south.
It might makes sense to have your retirement portfolio in place a couple of years before you actually walk out the door. Then, pick a time about seven to 10 years in advance of your desired retirement date to begin your transition. So, for example, let's say you decided that you wanted 40 percent of your portfolio in bonds when you retire, want the portfolio set up two years before the actual date, and want to start 10 years before retirement to begin to adjust the portfolio. Your portfolio today is 100 percent stocks.
You have an eight-year transition period. So, beginning 10 years before retirement, move 5 percent of the portfolio each year to short-term bonds. Two years before retirement you will have your 40 percent in bonds, and can look forward confidently to retirement without worrying too much about what the market does.
Of course, if stocks earn more than bonds during the transition period, you will have a somewhat smaller nest egg. Economists call that potential underperformance an opportunity cost. But, you will have greatly reduced the chance that a possible market crash will leave you unable to retire at all. So, the opportunity cost may be a small price to pay for peace of mind.
An investment strategy isn't necessarily about maximizing returns while ignoring risk. Most often the appropriate strategy is the one that will maximize the probability of a successful outcome. That requires considering both risk and return. Migrating early to your preferred retirement portfolio greatly increases your chance of a successful retirement experience.
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