EagleTribune.com, North Andover, MA

April 28, 2013

Investing your retirement nest egg

Financially Speaking
John Spoto

---- — The transition from employment to retirement warrants a reassessment of annual income and spending to estimate how much will be needed each year from the portfolio.

Once this is determined, retirees must decide how to invest their nest egg to generate sufficient and sustainable income for as long as they live. The decision involves two key interrelated factors, both of which the investor can control. The first is the asset allocation of the portfolio, and the second is the spending strategy employed during retirement.

Asset allocation is the percentage of a portfolio invested in the broad asset classes of stocks, bonds and cash. These assets behave differently (i.e. one may rise when the other declines) under various economic and market conditions and therefore tend to reduce the wild swings in the portfolio.

Asset allocation should be the top consideration when constructing an investment plan because it is the most significant determinant of a portfolio’s performance. The adage “Don’t put all of your eggs in one basket” characterizes the diversification benefits of a sensible investment mix.

As retirement approaches, investors often shift more of their assets toward stable, income producing investments such as bonds, and away from more volatile, growth oriented ones like stocks. Although this is generally a sound practice for retirees who rely heavily on investment income and have less time to recover from market declines, they sometimes take this concept too far and abandon the time-tested principle of a diversified plan.

Spending strategy during retirement refers to the way retirees take withdrawals from the portfolio to meet spending needs. Investors typically employ one of two approaches: the “income only” method or the “total return” method.

Using the “income only” method means that investors spend only the income (interest, dividends, and capital gains distributions) generated by the portfolio and do not touch principal. The goal is to preserve the portfolio’s value and avoid depleting it prematurely. While in some cases this may be a sensible approach, unless the amount of assets is substantial relative to spending needs, the retiree will be forced to tilt the portfolio’s allocation heavily toward income-producing assets and reduce growth-oriented assets.

This approach may initially generate the income needed today, but at the expense of growing the portfolio so it can meet spending needs later in retirement. Furthermore by reducing the diversification of the investment plan, the retiree unnecessarily increases its risk and reduces its tax-efficiency. The net effect of this strategy is to decrease, not increase the portfolio’s longevity.

The “total return method” will likely be a more effective strategy for most investors whose goal is to generate a sustainable income stream in retirement. With this approach, the retiree builds a diversified portfolio of assets that balances the need for current income with capital growth in order to meet spending requirements twenty, thirty or more years in the future. The investor then draws from the income first. If this proves insufficient to meet expenses, then the balance is taken from the principal.

This strategy requires that we overcome our instinct to “not touch the principal.” The reality is that money is money whether it comes from portfolio income or appreciation. In other words, it is the total investment return that matters and the source of that return is irrelevant.

Retirees face the challenge of converting savings accumulated over a lifetime of work into income that will last for as long as they live. With interest rates on income producing investments near historic lows, the task may be even more difficult today. Still, the fundamentals of building a sound, long-term investing plan remain unchanged: spend less than you earn, and invest sensibly in a diversified, tax-efficient portfolio that is consistent with your retirement goals.

John Spoto is the founder of Sentry Financial Planning in Andover and Danvers. For more information, call 978-475-2533 or visit www.sentryfinancialplanning.com.

This article is for general information purposes only and is not intended to provide specific advice on individual financial, tax, or legal matters. Please consult the appropriate professional concerning your specific situation before making any decisions.