Preparing for retirement

Preparing your portfolio for retirement can be challenging without a well-crafted plan.

Commentary on investing generally focuses on the accumulation phase of saving and investing to build up a nest egg of assets and the retirement phase when you use your assets to create an income stream to pay for your life.

But what receives less attention is the phase in-between, when you transition to retirement.

For many people the transition to retirement may not go as planned as health issues, corporate downsizing or burnout throw a wrench in plans. For people with adequate savings retirement may come early.

The challenges of retirement planning

Investing theory tells us that as we approach a goal like retirement it is important shift our portfolio into more defensive assets to limit volatility.

This is to combat sequencing risk, which is a fancy way of saying that if the market drops significantly as you start drawing down your portfolio it may not last long enough to cover your retirement.

Sequencing risk is a legitimate concern. But longevity risk is a concern as well which is the potential for outliving your money.

To address longevity risk the best approach is to keep growth assets in your portfolio. If the ways to address those twin risks seem conflicting it is because they are. The heart of this conflict is that none of us know how long we will live which makes it very difficult to plan retirement.

Aggressively de-risking your portfolio by shifting to defensive assets increases the chance you will outlive your retirement savings. Not being aggressive enough means that if the market drops significantly early in retirement you may never recover.

The bucket approach to investment strategy

The bucket approach to portfolio construction is designed to mitigate the twin risks retirees face.

Sequencing risk exists because the spending needs during retirement necessitates the selling of assets in down markets. Forced to sell low there is less of an opportunity to take advantage of market recoveries. This means that a retiree could run out of money prior to death.

The central issue is not the market drop. That periodically happens in markets. The real issue is the need to sell during these downturns. The bucket approach addresses this issue by creating short, medium and long-term grouping of assets.

The cash bucket

The short-term bucket is invested in cash and is designed to meet near term spending needs. If the market drops significantly retirees can draw on this cash instead of selling depressed assets.

Cash has no volatility. A dollar is a dollar and will not change in value at all in nominal terms.

There are several factors at play when making a decision about the size of the cash bucket.

Since the purpose of the cash bucket is to ride out market volatility the question is how long of a time period is sufficient. The average bear market takes 27 months to recover and reach the value before the fall. But in some cases, the period has extended for 5 years in particularly harsh bear markets.

Some retirees will decide that a one-year cash supply is enough.

The medium-term bucket

The medium-term bucket is invested in income generating assets like bonds to balance the need for medium-term certainty with the need for a higher income return above that of cash.

Bonds bounce around in price less than shares so any allocation to bonds will lower the amount an overall portfolio changes in value especially in a ‘bad’ year.

The long-term bucket

The longer-term bucket is invested in shares and property to protect against inflation and guard against longevity risk.  

As the cash bucket is spent down over time, the long-term bucket will be used to replenish those assets through asset sales and dividends and interest income.

Final thoughts

The retirement income challenge is to have savings available to meet planned and unplanned expenditure, and to have confidence that money will be available when needed. With the uncertainty around investment markets, life expectancy, expenditure-needs and inflation, maintaining flexibility is important.

The bucket approach lets an investor capture the long-term return benefits expected from shares, by riding out the downs and managing the risk that money is not available to be spent when needed.