Accumulating a portfolio is half the battle. The other half involves getting your money back when you need it. After all, future cash is surely what present investing is all about.
Our advice may often seem like it’s aimed solely at those in the process of accumulating money—often for retirement—but not those already retired and looking to use their savings for income.
But when it comes to generating income for important expenses such as living in retirement, we feel something like a balanced mutual fund loses its appeal. That’s because the most important feature in generating income from investment is control over your investments. And when you invest in a balanced fund, you give up most control to your portfolio manager.
By control, we mean the ability to plan with certainty when you’ll get your money back from an investment. If you have that, you can plan what amounts to a steady pay check. Unfortunately, of course, that kind of certainty usually comes only from fixed-income investments that will likely deliver low returns over the long term.
Split your portfolio in two
When you expect to take money out of your investment portfolio, we suggest splitting your total portfolio in two. The first part should provide the cash you need when you need it. And it should do so with near certainty for at least five years. Ten years may be better for you as you approach retirement—depending on your resources and risk tolerance. The second part is all the rest. This part can produce more erratic, but hopefully higher, returns since you have your short-term needs covered.
We, and many investment advisers, recommend equities only for those who can hold for at least five years. That’s because they’re much too volatile to count on for cash in the shorter term. But equities also provide the potential growth you’ll need over the longer term.
Suppose, then, that you have a portfolio worth $1,000,000. And you plan to retire in just a few months. First, determine the amount of income you can reasonably take from your investments.
We recommend about four per cent per year before income taxes. That’s based on a balanced portfolio. If, for example, you hold $400,000 in fixed income, the Financial Planning Standards Council projects long-term annualized returns of 2.9 per cent. A $600,000-portfolio of diversified stocks is projected to return about 6.3 per cent per year. You’ll, therefore, realize an overall annual return of about 4.9 per cent. Therefore, we think that four per cent is a conservative, reasonable expectation. To plan on more means accepting the increased risk of getting less.
Fixed-income securities work best
Now, expecting a before-tax annual income of $40,000, you can prepare 10 years’ worth of income using GICs, bonds or stripped coupons. Invest $80,000 in one security (or group of securities) for each of one through five years to maturity (see below). Then, next year, and each year after, you’ll get $80,000 back, plus whatever interest you earned on your security. Keep about $40,000 for your spending needs and reinvest the rest in another five-year security. In total, you’ll have $400,000 invested in fixed-income investments, or 40 per cent of your total portfolio.
Or you could prepare for fewer years of income payments if you have a higher risk tolerance.
Control your securities
We typically recommend fixed-income securities with no more than five year to maturity. As they mature, if you don’t need the money, reinvest for another five years. Even that can add an element of risk.
Buying bonds that mature in, say, 2040 makes little sense for most investors. These bonds guarantee a fixed return for 20 years. But would you take a job with a contractually-fixed salary for 20 years? Insurance companies buy these bonds to meet fixed obligations on the death of policyholders far into the future. You won’t likely have the same needs.
This is an edited version of an article that was originally published for subscribers in the June 26, 2020, issue of Money Reporter. You can profit from the award-winning advice subscribers receive regularly in Money Reporter.
Money Reporter, MPL Communications Inc.
133 Richmond St. W., Toronto, On, M5H 3M8, 1-800-804-8846