James debunks common misconceptions about retirement portfolio allocation and explains how to factor in your pension, social security, and other fixed-income sources into your plan.
He discusses the importance of dividends in assessing investment performance, risk capacity and tolerance, and how mastering them can help determine your optimal retirement portfolio allocation.
How should you allocate your portfolio in retirement, considering pensions, social security, and other fixed-income sources?
What is risk capacity, and how does it factor into portfolio allocation in retirement?
3:34 The wrong way
5:09 The right way
5:14 Example 1
7:59 Risk capacity
14:53 Example 2
19:05 Another consideration
21:00 Risk tolerance
21:40 Example 3
22:28 The emotional side
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One of the most important financial decisions you'll make in retirement is deciding what percentage of your portfolio you'll allocate to different types of stocks and bonds. The right way to approach this is to base your portfolio and fit your portfolio within the context of other income sources you might have. So, for those of you who have pensions or social security or other fixed income sources like that, if you're not including those sources into your overall portfolio allocation, you're likely doing it the wrong way. So in today's episode of Ready for Retirement, I'll show you how you should include social security, pension and other fixed income sources into your overall plan so you can determine the right allocation for you. This is another episode of Ready for Retirement. I'm your host, james Cannell, and I'm here to teach you how to get the most out of life with your money. And now on to the episode. Today's episode is based on a listener question, which is great. It means that we actually get to apply a very real world scenario to see what are the principles that we should be looking at. How do we apply it to this example? But, more importantly, how can the rest of you apply it to your individual circumstances? So let me read the question that was submitted and then we'll go through an episode to address it. This question comes from Michael, and Michael says Hi James, fabulous podcast. Thank you for explaining complex issues in plain language. By focusing on the most critical points, you allow your listener to understand better, make informed decisions and make sure we're asking the right questions. My question is this how should I think of my pension when determining the mix of stocks, bonds and guaranteed investments in my retirement account? Should I use the present value of my pension and count that as guaranteed income? Can the rest of my retirement portfolio go heavier on stocks because I have a pension? I have the same question on how to think about social security. My wife and I work for the federal government. We are in our early 50s and plan to retire in 8 to 10 years. Together we will have a pension that will pay about $5,000 per month. Social security will also pay about $5,000 per month together at age 65. We have about $1.6 million in investments between retirement accounts, other investments and savings, and our current investment mix is about 75% stocks and 25% everything else. Thank you, michael. Michael, thank you for that question. We have some data there. We have a very real-life situation. His question essentially is how do I think of my pension or how do I think of social security, which are going to be fixed and come sources in retirement? How should I use that information to help inform what the right portfolio allocation is for me? That's what we'll be addressing today. Before I do so, I want to highlight the review of the week. This review comes from a user named TJ6358. Tj6358 leaves a 5-star review says Super solid and well-organized. My favorite retirement podcast. Good, short topics with solid info, the least amount of rambling. Wish I'd found this earlier, also available on Spotify. Well, tj6358, thank you very much for that feedback. Thank you to all of you who are leaving reviews. As I say every time, the reviews help me. I always appreciate you getting those. They also help everyone who is looking for good information on retirement. When people are searching for podcasts to find that relevant information, they're looking at reviews. Every time you leave a review, it helps me, it helps others, everybody wins. I appreciate all of you have taken the time to do so. If you've not already left a review, please go ahead and do so. Hit 5 stars if you've been enjoying this podcast or if you've found any value in it at all, and also be sure to share it with friends or family, with coworkers or anyone who you think could benefit from the information. And with that, let's jump right into the episode for today. Let's start, as we're looking at this, by addressing the wrong way that people typically think of this. The wrong way and again, this being how should I allocate my portfolio and specifically, how should I allocate my portfolio in retirement Early on in your career? It's easy enough. You've got 20 years till you retire. You've got 30 years till you retire. You can be in a really growth-oriented portfolio because you're not going to use that money for a long period of time. So that can be fairly common, generic but good advice for people that have a long way to go until retirement. That doesn't work in retirement. Here's what the wrong way of approaching it is. Most times and this is often if you're working with a financial advisor or maybe you're feeling like a questionnaire online to get your 401k allocation or whatever the case might be they'll have you fill out a questionnaire. They'll ask how old are you? When do you expect to take funds from your portfolio, what amount of a declining your portfolio would make you nervous those types of things and what the questionnaire does is it comes up with a generic portfolio and most commonly that portfolio is going to be a 60% stock, 40% bond portfolio. For those of you in retirement, nothing inherently wrong with that, but that might not be the right portfolio for you. I would say it's no more likely to be the right portfolio for you than a 70, 30 mixed might be, or even a 50, 50 mixed might be. It's just kind of a cookie cutter, generic starting point and yes, there's some good benefits to a 60, 40 portfolio, but we're not looking at the benefits of the portfolio in general. We're looking to see what's the right portfolio for you, what portfolio, due to your specific financial circumstances, most fits your situation. That's what we're going to be addressing today. So if that's the wrong way to approach it, here is the right way to approach it. The right way is you have to look at it from two different angles. One angle is what I call your risk capacity. The other angle is what's called your risk tolerance. Let's start with risk capacity. Risk capacity is purely a financial thing, so it has nothing to do with emotions or how would you feel about this amount of ups and downs in the market? It's a math problem, it's an equation, and here's how I like to look at it. Let's assume that you need $40,000 per year from your portfolio. Just to make up a number. Let's also assume you have $800,000 in your portfolio when you go into retirement. Well, let's start with the assumption that your portfolio is all stocks. Let's do some basic math. Well, 40,000 per year divided by 800,000, that represents a 5% per year withdrawal rate. Us stocks historically have averaged 10% per year If we go back the last 100 years or so. So if we look at this, it seems like the math checks out right. I average 10% per year in growth. I take 5% per year out in withdrawals, which means there's 5% left to stay in the portfolio, compounding to continue growing at larger. That seems to work out until you realize the market's not going to give you a consistent 10% per year. In fact, never once has the US stock market returned exactly 10% per year over the last 100 years or so. Now you're going to get returns that are either much larger or much lower in anywhere in between. For a perspective, if we go back for the last 100 years, there's been one year where the stock market returned 54% in a single year. There was another calendar year where you lost 43% in a single year. So you look at those two scenarios. Those are very different outcomes going into retirement. So let's assume that you have that negative 43% experience. So you retire, you have $800,000 in your portfolio, you take 5% out and your portfolio drops by 43%. Well, you started that year with $800,000 in your portfolio, but by the end of it now you're down to $416,000. Let's play that out one more year. The following year you take out another $40,000. And when you start to do the math there, what started out as a 5% per year withdrawal rate, now all of a sudden you're taking 9.6% out of your portfolio, meaning your portfolio needs to grow by over 9.6% that year just to stay even, not to go down any further in value. So when you look at that, 9.6% likely isn't a very sustainable withdrawal rate. There's a very low probability of outcome if that's what you're taking out of your portfolio. So that's the problem. Your portfolio, based on your financial plan in this example, does not have the capacity to take on that much risk. You can't really afford to be 100% stocks in that scenario because if the market drops and if you have to take that 5% out or the 40,000 per year, you don't have the capacity to accept that much risk in your portfolio. So this is going back to what we talked about of risk capacity. Now I want to be very clear here. This is specifically talking about a retirement portfolio. If you look at stocks in the long run they're really not that risky, depending on how you define risk. Jeremy Siegel has a great book called Stocks for the Long Run and in that book he says quote for 20 year holding periods, stock returns have never fallen below inflation. He then goes on to say the worst 30 year return for stocks remained comfortably ahead of inflation by 2.6% per year, a return that's not far below the average performance of fixed income assets. In other words and quote by the way in other words, what Jeremy Siegel is saying is he's saying look over long periods of time, the worst case performance for stocks, historically speaking, has been the average performance of what you get in what are considered more quote unquote stable or conservative investments, so bond investments. So if worst case scenario is you're getting the average return of a conservative investment and best case scenario is you're getting a whole heck of a lot more, there's not a whole lot of risk to that type of investment if you have a long enough holding period. So let's want to be very clear here. When I'm talking about risk capacity and how much can your portfolio accept in risk, I am specifically talking about a retirement portfolio, and by retirement portfolio I mean one that you are actively drawing down in your retirement. So if you have time on your side, the stocks, historically speaking, don't pose much of a risk. What risk is? In my opinion, the way I choose to define it is. Risk is defined as the possibility of permanent loss of capital Over long periods of time. Stocks have never permanently lost capital, assuming you've been well-diversified. There's been plenty of instances where you've lost capital if you are too concentrated in one stock or you made a bad decision at the wrong time. But if you remain diversified or remain invested, there hasn't been a long period of time where you've lost your capital. If, however, we go back to our example, you have $800,000 in your portfolio, you need $40,000 per year. Well, if you're forced to sell $40,000 when your portfolio is down, that is permanent loss of capital. That is risk, because you've condensed your timeframe there. So let's go back to risk capacity. In other words, how much does your portfolio need to be invested outside of stocks? So how much do you need in some type of a short-term bucket or short-term buffer to protect against the inevitable downturns that are temporary but are ever present in the stock portion of your portfolio? Well, there's no perfect science to this, but I like to start with five years worth of living expenses. Should we think about allocating to more fixed or stable investments? Why do I say this isn't a perfect science? Why five? Well, a few somewhat non-scientific reasons. Number one the average bear market takes two and a half years to go from peak. So one of the market peak to trough. Okay, it hit its bottom back to break even again. That's a two and a half year time horizon. So by having five years set aside in something more stable, more conservative, you've essentially doubled your protection against an average down market or an average bear market. The longest it's ever taken investor this is another quote, by the way, from Jeremy Siegel's book Stocks of Long Run. He says, quote the longest it has ever taken an investor to recover an original investment in the stock market, including reinvested dividends, was a five-year, eight-month period, from August of 2000 through April of 2006. End quote Now for some context here he's talking specifically about post-Great Depression years, because a lot of you probably hear that in say five years, eight months, that's a long time. But, james, have you heard about the Great Depression? There was a much longer downturn. Yes, but as a side note here's a few things to consider. Hey everyone, it's me again for the Disclaimer. Please be smart about this. Before doing anything, please be sure to consult with your tax planner or financial planner. Nothing in this podcast should be construed as investment, tax, legal or other financial advice. It is for informational purposes only. Let's look at the Great Depression In 1929, that's when the stock market really began its horrible plummet. The market, the Dow Jones, opened at 307 points. It didn't open a new year above 307 until 1955, 26 years later. You'll hear a lot of people say my goodness, if you had invested at the beginning of the Great Depression, it took you 26 years to break even. That's misleading. Number one. The reason that's misleading is because it doesn't include dividends being reinvested. Those stocks that went down quite a bit in value. They're still paying dividends over that time period. It was still a horrible time to be an investor and it still took a very long time to recover. But if you include reinvested dividends, that 26 year break even gets condensed down to 15 years. So still a long time. But here's another thing that people don't talk about. There was pretty significant deflation during that time. Over the next 10 years so from 1929 and 1939, deflation averaged 2% per year. So if you look at this in terms of real return real return essentially being what's the nominal return, so that you see in the newspaper or when you log in somewhere to see the performance of the market minus whatever inflation was In this case inflation was negative, it was deflation. When you factor that in, it was a nine years to break even, so still a very long time. Could that happen again? Yes, anything is possible. But there are so many differences in today's market to the market we had back then. Number one there's a huge amount of speculation. Back then, number one there's a lot of fraud. Back then, a lot of this wasn't regulated. There's just the wild wild west of how much you could get away with in manipulating stock prices. And all of this was exacerbated by the fact that a lot of people were purchasing stocks at this time. On margin Margin means you borrow money to buy stocks. So when you borrow money to buy stocks and those stocks start falling, there's what are called margin calls, and when you have a margin call, it means you have to pay the bank back what you owe them. Well, if your stocks fall enough, you end up owing the bank more than you can redeem from the value of your stock. Now that starts a domino effect of if everyone not everyone, but many people were buying on margin, a huge percentage of people were buying on margin. It led to this domino effect of everybody's stocks getting called, everyone's trades being called. It was just a bad experience for a number of different factors, number of different reasons. But need this to say could that happen again? Yes, it could happen again. Probably not for the exact same reasons or same exact circumstances. But as we're looking at this risk capacity and what do we need to be prepared to protect against anything post World War 2, it's taken five years, eight months to recover If you're just invested in US investments. If you're more diversified, the break even time has been shorter. So that's a non scientific reason that I like to think through for having five years worth of living expenses in a non-stock investment. So let's now apply this to the example we mentioned above. You have an $800,000 portfolio and you need $40,000 per year. Well, very simplistic way of doing it as a starting point is take that 40,000 per year that you need, multiply it by five, so that's $200,000 that you would want to have in bonds Now. By the way, when I say bonds, this could be CDs, this could be money market funds, this could be T bills, this could be corporate bonds, this could be short term bonds, this could be long term bonds, this could be high yield bonds. There's a whole bunch of different types of bonds. So I'm using this as a catchall for non-stock investments, relatively more stable investments, but there's not just one type of bond. Really, you want to own the right makeup of these different types of bonds to be as protected as you can be. But, just as an aside, that's what I mean when I say bonds Now in this portfolio, if you have that $200,000 there in bonds, theoretically the rest is now freed up to be more of a growth-oriented investment Because you're protected now from the short-term downturns of the stock market. That frees you up to be more aggressive, to grow more with the rest of your holdings. So if we play that math out in this example, 200,000 in bonds leaves 600,000 in stocks. That means a 75% stock portfolio, 25% bond portfolio in this case would be a good starting point in terms of understanding what should that retiree portfolio look like. Now in Michael's case? I don't know exactly what their expenses are but, going back to his question, they will have, upon retiring, 10,000 per month in pension and social security. To determine Michael's risk capacity or the risk capacity of his portfolio, I wouldn't need to know his expenses, but I do know this. If Michael's expenses were, say, 10,000 per month or less, then his risk capacity becomes 100% stocks. Why do I say that? Well, because a downturn in the stock market wouldn't force him to sell. They would be able to still fully live on income from pension and social security. So he has the capacity to have a growth-oriented, more risky, aggressive portfolio because he wouldn't be forced to sell. If, for example, michael had expenses of 15,000 per year or per month I should say 15,000 per month then that would be a different story. Then in that case, if $10,000 per month of his expenses are coming from social security and pension, 5,000 is the shortfall to get to 15,000, then Michael and his wife they would need 5,000 per month or 60,000 per year to come from their portfolio. Well, what type of a portfolio do you need to meet that? Let's start with the starting point that we just looked at 60,000 per year. Multiply that by five, that equals $300,000. They don't need that today because they're still eight to 10 years out from retirement, but by the time they retire, that's what they would need. Let's just make up some hypothetical numbers. Let's assume we fast forward eight to 10 years and Michael and his spouse are retired. Let's assume they now have $2 million in their portfolio. By the way, hopefully they'd have a whole lot more. Hopefully a $1.6 million portfolio is worth a lot more than just $2 million after eight to 10 years of growth. But to keep numbers simple, I'm going to assume they have $2 million in their portfolio. Well, with that portfolio, if you had 85% stocks and 15% bonds, then that might be a good starting point in terms of what your risk capacity is. That's because 15% of $2 million equals $300,000, which equals five years of living expenses of $60,000 per year. There's a bunch of variables in here that I'm just glossing over, that you want to apply in your actual situation. One is inflation. So we're looking at numbers today, but Michael has eight to 10 years until retirement. The other is portfolio growth. As I mentioned, I'm assuming $1.6 million turns a $2 million, it's probably going to turn into a lot more. Hopefully turns into a lot more. So factor that in Taxes. If you need $15,000 per month or $10,000 per month or $5,000 per month, that's probably after taxes. What's the impact of taxes going to be on this? I'm oversimplifying this here, but just want to give you some perspective of how to think about this. Now, I said this is a very basic starting point. Some people might be thinking well, if this is basic, what else do we need to be thinking about? This sounds like a pretty good place just to start and to end. Well, it could in some cases. But here's the next thing I'd want to consider what's the yield in terms of the dividends and interest that this portfolio is creating? Let's go back to Michael's portfolio. Let's assume that his $2 million portfolio at the time of retirement has, let's say, a 3% yield In terms of the interest generated from bonds. In the dividends generated from stocks, 3% comes out to $60,000 per year in cash that this portfolio is creating. Well, that happens to be the exact shortfall. In the example that I made up for him, if he needs $15,000 per month and $10,000 is coming in from Social Security and Pension, there's a $5,000 per month gap, which is $60,000 per year. So if we're looking at this, and if we go back to remembering what the goal of bonds is, which is to protect against force selling, we could look at this and say well, if you have an all-stock portfolio that's generating 3% per year in dividends, you could make a case to stay all stocks, because the dividend income alone remains pretty sticky, even when stock values are fluctuating quite a bit, like they do in market downturns. So that's another layer that I'd want to look at here not just how much do you need to have in fixed income to be able to protect against downturns, but also factor in cash inflows from dividends, from interest, from things like that. One of the points, though, that I want to drive home here is that the impact of outside income sources so pensions, annuities, social Security, even rents, anything that you are receiving income from that's not associated with your portfolio all of those things being equal those will increase your risk capacity. The more income you have from outside sources, the less of your portfolio you need to depend upon to meet your living expense needs. So I think a general approach, a general rule of thumb for people is the more you have in these outside income sources again, all that's being equal the less you'll need in stable investments from a risk capacity standpoint. Now, that's only one standpoint, the other part. So part two, is your risk tolerance. So in step number one, we pay no regard to the emotional side of investing. If we were to actually do that, we'd be approaching this wrong. We're not robots. We're not spreadsheets. The reality is market downturns do impact us on an emotional level. It's not fun to see your portfolio swinging way up and way down. So 100% stocks could make a lot of sense on paper. It could deliver all of your income needs. It could even protect you against downturns, knowing that you still have income sources to rely upon. But is it right for you? That's a question only you can answer. To put that in perspective if you have a $2 million portfolio and it's down 43% in a year, 12 months later, your $2 million portfolio is now $1,140,000. It's going to feel like a big setback. It may have taken you years to grow from $1,1 million to $2 million in your portfolio and over the course of 12 short months, you're right back where you started. Not just that, it's not just okay now I have $1,14 million in my portfolio, but the news is talking about how rosy everything is and there's full confidence that the worst is behind us and there's better days to come. That will not be your experience. It's going to be $1,14 million, with every news station around talking about how it's only going to get worse. Now, whatever crisis of the day they're pushing is different than all the other times in the past, and you should brace for more downturn. You should brace for more pain. They may be right or they may be wrong. The reality is they don't know, but that's the messaging you're going to hear. Risk tolerance is all about what's your comfort level with this, you can't be too conservative. I see too many people say I just don't like the ups and downs, so they get too conservative. If we're just paying attention to the emotional side of investing, we might miss the financial side, which is we need our portfolio to deliver some return for us to be able to accomplish our goals. But if all we're focusing on is the financial side and we don't pay attention to the emotional side, you might get yourself into a portfolio that on paper makes sense, on spreadsheets and software makes sense, but in reality causes you a huge amount of distress. So when you're looking at this pensions and social security and other outside income sources they do absolutely impact your risk capacity. I would say that every dollar extra you have in outside income sources is one fewer dollar your portfolio needs to generate. So there's a direct proportionate correlation between those two things. On the risk tolerance side, though, it's more of a feeling, it's more of an emotional thing. So, yes, pension, social security, outside income sources I think they do help people feel more comfortable being in a more of a growth portfolio because they know they've got their income elsewhere. But you still have to ask yourself how will I feel when the stock portion of my portfolio is down 30, 40%? I don't say if, I say when, because that will continue and over the course of your retirement. If you're 16 and you have a 30 year retirement, there's going to be a handful of times when you go through really painful experiences. So you need to make sure that your portfolio has the right risk capacity in terms of what mix of stocks to bond should I have. But it's also right for your risk tolerance, which is knowing yourself and knowing what you can deal with through the ups and downs of the market. So, as we look at this, michael, I really appreciate that question of hey, we have pensions, we have social security. That will absolutely impact your risk capacity. It may even impact your risk tolerance, but making sure that there's a marriage between these two things the financial part of the equation and the emotional part of the equation to come up with a portfolio that's right for you. So I hope that was helpful, michael. Thank you for your question. Thank you to all of you who have left reviews and continue to support the show by doing so. If you haven't done so already, check us out on YouTube. Under James Cannell as the channel name, you can find this podcast. You can find other great content that we release as well and, with that being said, I will see you all next time. Thank you for listening to another episode of the Ready for Retirement podcast. If you want to see how root financial can help you implement the techniques I discussed in this podcast, then go to rootfinancialpartnerscom and click start here, where you can schedule a call to one of our advisors. We work with clients all over the country and we love the opportunity to speak with you about your goals and how we might be able to help. And please remember nothing we discuss in this podcast is intended to serve as advice. You should always consult a financial, legal or tax professional who's familiar with your unique circumstances before making any financial decisions.