I enjoyed my first foray into live radio last night with an appearance on Lance Roberts’ streettalklive broadcast. (To listen to my segment, click here: Download Streettalk Live 2). We chatted about retirement, and he shared his wisdom on important issues like how much money one needs to retire, and how retirees should allocate their nest eggs between stocks and bonds.
I’ve discussed the importance of determining your own tolerance for risk in order to figure out how much of your portfolio you should allocate to stocks. And by risk tolerance, I am referring to how much you feel like killing yourself when you see your nest egg shrink.
As I’ve mentioned before, I may have been a little too risk tolerant when I initially set up my own retirement portfolio. When the stock market lost about half of its value in the first year of my retirement, I might have felt a little more comfortable with a slightly more conservative allocation. Live and learn. But what if you don’t want to learn the hard way like I did?
You already know how to target the size of your retirement nest egg. Let’s say you are retiring at age 65 and are targeting a 4% withdrawal rate. You’ll need a nest egg equal to 25 times your annual expenses that aren't covered by other income sources such as Social Security, rental income, or part-time work. But how do you allocate those assets among stocks and bonds in a way that will allow you to sleep at night during a market tumble, before you actually suffer through a market tumble? That’s where Lance has an interesting suggestion.
First, look at your projected expenses. Then figure out how much money you will need just to cover your “Alpo diet,” meaning the absolute minimum you need for basic expenses before you have to start eating dog food. Maybe not such an appetizing image, but you get the drift. Perhaps some of this is covered by your Social Security or other income. But to the extent that it is not, invest enough of your nest egg into the safe part of your asset allocation to generate the income you'll need to meet your basic needs.
Then to keep up with inflation, you will want to allocate the rest of your nest egg to equities. This part of your nest egg will cover the wants rather than the needs. That way, if the market runs into trouble, you’ll be able to makes some adjustments to your spending on discretionary items, while still ensuring that you get to eat normal food for dinner.
I took a look at how this approach would translate to my own allocation. Sixty percent of my budget is for non-discretionary items, housing, insurance, utilities, groceries, health insurance--things like that. A little more extravagant than an Alpo diet, but that represents the basic cost of operating our life as is right now. The other 40 percent of our expenses are for discretionary expenses, things we could cut in a pinch, but really wouldn’t want to.
That would translate to a 60% bond allocation and a 40% stock allocation. Which is a little too conservative for my taste, especially since I’ve got potentially 50 years to cover. But consider the same breakdown if I were 67 years old. That would be when I am eligible for Social Security. Social Security should cover about 20% of my expenses. (I will not earn the maximum Social Security benefit since I did not work long enough to earn the full benefit.) In that circumstance I would only be aiming to cover 80% of my expenses with my own nest egg. After applying a little math, that translates to a 50/50 split between stocks and bonds. (Since the first 20% of my budget would be taken care of by Social Security, only 40% of my expenses would remain to be covered for basics and 40% for fun stuff.)
While this approach may not exactly hit the mark for me now, it seems a pretty reasonable way to tackle the issue, perhaps with a little fine tuning to really make it your own.
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