Asset Dedication Part IV: Case Study “Retired Boomer” Sandra
Having accumulated a retirement nest egg is a big deal. Retiring comfortably is a dream for many Americans.
It is crucial to understand how the assets should be allocated when a retirement nest egg is required to cover living expenses, and everyone would like to protect it as long as possible.
The asset dedication approach is only a proper investing strategy during a distribution period.
Asset Dedication for the Distribution Period
Sandra is 65 years old. She just retired, and she lives in Chicago. She is divorced and has a 35-year-old son. She managed to save $2,000,000, and her retirement nest egg is a primary source of living expenses, and she would like to protect it as long as possible.
Individuals like Sandra ask three common questions when they retire:
- How much can I withdraw?
- How much is the return of my portfolio?
- How long will my nest egg last?
Obviously, the more she spends, the faster she empties her nest egg. The higher her portfolio’s return, the longer her money last.
There is a withdrawal rate at which her funds never run out. It happens when her withdrawal is less than the return of the portfolio.
Many researchers have investigated the impact of withdrawal rates on retirement portfolios. Some of the most exhaustive research was conducted by professors at Trinity University in Texas.
They published a whitepaper entitled “Retirement Savings: Choosing a Withdraw Rate That is Sustainable.”
This study has found that it is possible to find an asset allocation that, in 100% of all 31-year periods since 1926, supports a withdraw rate of 4% without draining the portfolio to zero.
It is crucial for Sandra to have a formal financial plan for retirement investing that will incorporate all variables, such as her cash outflows (spending), inflation rate, her income from Social Security and other sources, tax rate, and how long her nest egg should last.
When several iterations are done, she has a critical roadmap showing what to do in next decades.
The calculations of the financial plan must also solve the biggest problem she faces to construct a dedicated portfolio – a scheduling problem. Maturities and coupon payments of bonds, included in the dedicated portfolio, should match her cash outflows for an established period of time.
Of course, the formal financial plan is not set in stone. She has to periodically review and adjust it.
How Much to Withdraw
Sandra is about to set up her dedicated portfolio. Let assume the following scenario:
- She is 65 years old today, and her projection is to live until she is 100.
- Her nest egg should last at least 35 years.
- She would like to begin to travel a lot and spend about $80,000 annually in today’s money.
- The inflation rate is 3%.
- Her annual spending amount must be increased according to the inflation rate; i.e. next year she would like to spend $80,240.
- Social Security will pay her $25,000, and this amount will be adjusted annually by the inflation rate.
Simple math has shown that she needs approximately $97,000 in gross income annually in order to have $80,000 of income after tax in today’s money.
She has to withdraw $72,000 per year from her retirement investment portfolio, and this amount must be adjusted by the inflation rate, i.e. next year she would like to receive $74,160.
Her marginal income tax rate is 17%. Actually, not all of her withdrawals and income will be fully taxed. For instance, withdrawals from a Roth IRA and earnings in an IRA will be tax-free. The same is applied for withdrawals from regular investment accounts. Most likely, she will have more cash in hand.
Financial calculations have shown ( Table 4) that if she has $2,000,000 in her retirement account and she invests all funds in a dedicated portfolio of individual bonds with an average annual yield after fees of 5%, she is fully protected. Her portfolio will last until she turns 100.
If a Retirement Nest Egg Is Not Enough
What can she do, if we assume the same variables as in a previous example, but the amount of her nest egg is only $1,400,000?
Her investment account will be empty in 23 years. (Table 5)
To avoid drying up her nest egg, she can decrease her expenses or increase the return of her portfolio.
Reducing her expenses means a lower standard of living. Increasing her return will lead to taking more risk.
The return can be improved in two ways: by increasing the yield of your dedicated portfolio of individual bonds or by investing in equities.
Assume she makes the latter decision and puts money into a 10-year dedicated portfolio of individual bonds. She only has to invest $700,000 in this portfolio ( Table 6).
She invests another $700,000 in equities hoping to have a return on average of 11.53% annually.
During the initial ten years, her dedicated portfolio of individual bonds will cover all of her expenses adjusted for inflation, while her equity investments will grow unattached. Her bond portfolio is dried up after ten years, but her equities portfolio could more than double up to $1,507,100 (115.3% growth).
It is time to reset her dedicated portfolio of individual bonds.
At that moment, she has to invest $900,000 in this portfolio because of inflation-adjusted expenses. The rest of her nest egg capital is still invested in equities.
After another ten years, she again empties her dedicated portfolio of individual bonds, but her equities could grow up to $1,307,086.
It is time for money investing in a dedicated portfolio of individual bonds for a third time. At that moment, there is enough money to set a portfolio for almost 13 years.
Continuous Rolling Horizon
A portfolio reset every 10 years has one large disadvantage.
What if at the moment of reset, the stock market is in a severe correction?
She would need to sell her equities at a loss.
To avoid such risk and avoid drying up her dedicated portfolio of individual bonds, she can use a “continuous rolling horizon” approach.
After setting an initial 10-year dedicated portfolio of individual bonds, she could reset it every year. She simply needs to add more money to buy bonds by selling some of her stocks.
This approach will help to avoid selling equities in an unfavorable time.
In the End
Of course, the selection of investment approaches depends on your personal situation, risk tolerance, and goals.
However, it should be noted that only the asset dedication approach allows building portfolios with a defined time horizon.
Only individual bonds can help to set a portfolio with a target date when you need the money back and to have an assurance that you will entirely achieve the goal.