You’ve spent your whole life saving for retirement . Now you’re finished working, and it’s time to start spending what you’ve saved. For many investors, the transition can be confusing or even traumatic. How will you tap your portfolio?
As investors approach this transition from saving to spending they should take three steps: start with a retirement income plan, keep their portfolio invested and diversified, and then rebalance their portfolio periodically to generate the cash they require. Here we’ll discuss the last step — creating your paycheck when rebalancing.
Why is this important?
If you’re an investor, you’ve almost certainly heard of having an appropriate asset allocation to stocks and bonds, maybe 60% stocks and 40% bonds, and then periodically rebalancing. Some investments rise and others fall at different times under different market conditions. To stay on track, rebalancing helps keep your portfolio in balance based on your goals and tolerance for risk.
Fewer investors think of rebalancing as a retirement income strategy. A lot of investors try to construct a retirement income check from investment earnings alone, but it isn’t necessary — or most efficient. You’d need a portfolio of $2,000,000, for example, invested in the S&P 500 SPX, +0.67% today to generate $40,000 in dividend income. For many people a more feasible strategy is to consider a diversified investment approach instead — and rebalance.
How do I do it?
Consider John and Jane. They’ve been diligent savers and have built a solid balance to tap now that they’ve decided to retire. They’ve worked with a financial adviser, and determined that they’ll likely have a long life in retirement. They have $1 million saved — to round off the numbers and make it easy — and want to start retirement by tapping $40,000 from their portfolio before taxes along with Social Security and other income.
John and Jane start with mix of cash, bonds, and stocks recommended by their adviser. They’re in their mid-60s, and this mix of investments feels comfortable to them. A year from now, they plan to take their first portfolio withdrawal. Today, their portfolio looks like this:
Hypothetical portfolio – John and Jane
After a year in the market, what happens? Let’s imagine that the portfolio performed reasonably well, as shown below:
There are two nice attributes of interest and dividends: one, most portfolios generate them, and two, they’re always positive. However, they might not be enough to generate the income you need. For John and Jane, portfolio growth boosted their return, which provides a third portfolio income stream in addition to what they’re getting from interest and dividends. This may not happen every year. But on average, we expect that a diversified portfolio will grow over time.
Now that we see how their portfolio performed, how do they generate the cash they need? They rebalance, as shown below:
In this case, John and Jane chose to invest using mutual funds and exchange-traded funds (ETFs). They opted to automatically reinvest the distributions they received. At the end of the year, John and Jane rebalanced and sold shares to generate the $40,000 they needed.
What else could you consider?
• Interest and dividends vs. selling shares? John and Jane could have chosen to have interest and dividends transferred to a bank account first, and then sell shares if needed. For example, if they received $20,000 in interest and dividend payments — equal to 2% yield from their $1 million — they’d only need another $20,000 more from their portfolio. It can be easier, though, just to reinvest and keep the money working. This can also make the paperwork easier.
• Tapping “principal?” Some investors look at rebalancing and selling investments as tapping “principal.” Think of it instead as tapping all sources of return from your portfolio. Using John and Jane’s scenario, they didn’t tap any of their original $1 million principal, they simply used the portfolio gains as additional portfolio income.
• Down market? The risk of a down market is critical to retirees. Early in retirement, a big drop in your portfolio can be particularly damaging. A diversified portfolio with the right mix of cash, high-quality bonds, and stocks helps with diversification, but it’s not a guarantee that your portfolio won’t lose value. In a down market, consider cutting discretionary expenses, if you can. Do this, and you’ll limit the need to sell investments in a down market.
• What about taxes? Consider the tax implications of withdrawing income from your portfolio. For example, it typically makes sense to avoid selling any shares purchased within the last 12 months to limit short-term capital-gains tax treatment. Earnings withdrawn from a traditional IRA or 401(K) are taxed as ordinary income. Withdrawals from Roth IRAs or Roth 401(K) are not taxed at all.
A critical mistake people can make when it comes to retirement income planning is limiting their strategy to interest and dividends and neglecting the power of rebalancing to capture portfolio growth as an additional income source. And in addition to helping you take a more holistic approach to generating income, it has the added benefit of forcing a good habit of regularly rebalancing your portfolio back to its intended asset allocation based on your goals, time horizon and risk tolerance — an important fundamental of successful investing and one that’s even more critical for people approaching or in retirement.
Rob Williams, CFP, CRPC, is managing director, Income Planning, for Schwab Center for Financial Research.
Disclosure: The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.