By John Spitzer, Ph.D. and Todd Houge, Ph.D., CFA (February 24, 2012)
What mix of assets should form a retiree’s portfolio? Conventional guidance for asset allocation often uses pie charts to show the percentage weight of the portfolio assigned to each asset class, such as stocks, bonds, real estate, and cash. For example, one popular financial guru recommends the following portfolio mix for retirees: 35% stocks, 40% bonds, 15% real estate, and 10% cash.
We believe using percentages to form a retiree’s asset allocation, while easy to explain and simple to understand, is seriously flawed. Why? Consider the slice allocated to cash. Is it there for liquidity? If so, that is misleading. The size of the liquidity holdings or emergency reserves should be a function of your living expenses rather than the size of your total portfolio.
Then perhaps the cash is there to provide long-term diversification? If so, that is another mistake. For longer-term holdings, one can structure a portfolio of bonds that provides the same or better diversification with a higher return.
In our view, asset allocation should be linked to the size of the retiree’s portfolio and to his or her income from social security, pensions, and annuities.
A retiree with a large pension and a large investment portfolio can likely bear greater risk and allocate a higher percentage of the portfolio to stocks without the risk of running out of money in retirement. On the other hand, it is much riskier for a retiree with little guaranteed retirement income and a modest portfolio to hold a large allocation in stocks. If the equity market underperforms in the early years of retirement, the portfolio withdrawals can easily deplete the assets to the point where they can no longer sustain the retiree throughout retirement.
So what approach do we prefer? We favor a “layer cake” approach, where each layer represents a different portfolio objective.
The Layer Cake Approach
The first layer provides liquidity needs. The size of this layer is dictated by primary living expenses and any psychological desires to hold additional liquidity. Financial advisers commonly recommend holding a minimum of 3-6 months worth of living expenses in cash, money markets, or other liquid assets. We are a little more conservative and typically recommend 6-12 months of liquid reserves, depending on one’s situation.
The second layer provides a “don’t be poor” level of income. This income is the level needed to cover the “must-have” expenses, such as your home, basic transportation, groceries, etc. This layer is formed by assets that provide guaranteed retirement income – social security, pensions, and annuities.
Of these components, we actually like social security the best. Social security payments are increased annually with inflation, unlike most private pensions. Retirees can also supplement social security income by purchasing an immediate annuity, but in that case, we suggest deferring the start of social security and using the purchase money to cover the period of deferral. The cost of “buying” extra income by delaying social security is considerably cheaper than the cost of buying an immediate annuity in the marketplace, especially in today’s low interest rate environment.
For example, suppose one plans to take social security at full retirement age with annual payments of $20,000. If you defer social security for one year, the payments increase by 8% to $21,600. In essence, you have “paid” $20,000 to purchase an annuity with annual payments of $1,600, and payments adjust with inflation. Alternatively, using the $20,000 to purchase an annuity in the market would provide substantially less than $1,600 without any adjustments for inflation.
We suggest caution with “living benefits” annuities. These products guarantee a minimum payment combined with the possibility (if the market does really well) for the payment to be higher. These products often carry significant fees, high enough to make us skeptical that you will receive anything more than the guaranteed amount. Be sure to compare the guaranteed dollar payout with the payout from a similar “plain-vanilla” immediate annuity. We recently made this comparison for a colleague – the guaranteed payment for the living benefits annuity was about 25% less. (For more details, see our article on Living Benefits Annuities.)
For the third portfolio layer, we recommend a layer that provides “enough more to make you comfortable” – covering such things as additional travel and entertainment. For this objective, we like income-generating real estate, bonds, CDs, and perhaps high-dividend stocks.
The fourth and final layer is what we call the “tap in a good year” layer. In essence, it serves as the icing on the retirement cake. You can draw from this layer if the market does well, but you do not have to draw from it in a bad year. This is the layer for stocks, more speculative real estate investments, and other riskier assets that may provide higher returns and sweeten the portfolio for the future.
Example of the Layer Cake
Now, let’s explore an example of this approach in practice. Consider Jim and Judy, who are both 65 years old and planning to retire in one year at age 66. They have accumulated a nest egg of $800,000 in assets. Although Jim and Judy expect $37,000 in combined annual Social Security benefits, they need a minimum of $50,000 per year in retirement to cover their current annual living expenses. To feel comfortable, they want $70,000 per year in constant (inflation-adjusted) dollars.
How should Jim and Judy allocate their assets to achieve their goal? The pie chart recommendation cited above would shift their holdings to $280,000 in stocks, $320,000 in bonds, $120,000 in real estate, and $80,000 in cash. Applying projected real rates of return of 5%, 2%, 4%, and 0% to these categories, respectively, their portfolio will generate $25,200 annually in constant dollars. Including the $37,000 that Jim and Judy will receive from Social Security brings their retirement income to $62,200, well short of the $70,000 goal.
But Jim and Judy use the layer-cake approach. They start by focusing on their liquidity needs and allocate $50,000 to liquidity – about one year’s living expenses.
Next, they focus on their goal of generating a minimum annual income of $50,000, with no risk. At age 66, Social Security will provide only $37,000 per year, leaving a $13,000 gap. Yet, if they defer taking Social Security until age 70, their combined annual payments will increase by 8% per year to $50,300. However, this approach relies on the investment portfolio to fund the entire transitional period income. Jim and Judy invest $200,000 in a laddered portfolio of bonds, with staggered maturities of 1, 2, 3, and 4 years. They expect to draw $50,000 from these funds per year for living expenses.
Their next layer focuses on the desire for an additional $20,000 annually in near-certain income. They decide to invest $500,000 in a combination of high-dividend yielding stocks and real estate, which is giving them a 4% annual return. Since these securities are generally expected to adjust with inflation, this allocation should provide Jim and Judy with $20,000 of near-certain income to meet their goal.
Finally, the remaining $50,000 is allocated to higher-risk stocks. In good years, they anticipate being able to draw from this portfolio, but they will not be obligated to do so during market downturns.
With this approach, Jim and Judy have great peace of mind that they will be able to comfortably live their desired lifestyle in retirement. In essence, they have their cake and are able to eat it too.