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Create a Pay Cheque with a Total Return Approach

If you're looking to establish a sane, sustainable withdrawal plan in retirement, then follow these tips

Christine Benz 14 April, 2011 | 1:20PM

We've frequently debated income versus total-return approaches over the past few years, with partisans weighing in on both sides of the debate. I've made no secret of my own totalnik leanings, noting that investors who are fixated on generating current income from their portfolios are often taking on disproportionate risks.

But there's an area in which incomeniks have it all over the totalniks, and that's in ease of implementation in retirement. By using an income-oriented approach, you can create the equivalent of a steady pay cheque in retirement (or attempt to, anyway). But tapping your principal periodically, as you're required to do with a total-return approach, isn't just psychologically difficult. It's also a logistical headache. You have to figure out which accounts to tap for cash, which in turn affects where you're holding liquid assets, and you also have to figure out how to tap your accounts in the most tax-efficient manner possible. Given that, it's no wonder that so many retirees are attracted to investments that kick off current income.

Of course, annuities have long held appeal to those seeking to generate a pay cheque in retirement. But with interest rates as low as they are now, annuity payouts are also depressed. Financial-services firms have been busy cooking up new investment products to help retirees generate a pay cheque in retirement; many of them combine investments with insurance features. It's early days for most of these vehicles, however, and at this point, it's tough to give a ringing endorsement to any one option within this relatively untested group. Moreover, many investors are satisfied with their current investment portfolios; they're just not sure where to turn for cash when they need it.

That's where the bucket approach to retirement planning can be so effective. Retirement theoreticians often consider bucket strategies as too simplistic, but the concept resonates with many real-life retirees and the financial advisers who work with them. The basic idea is that you create a dedicated pool of assets, composed of cash and other very liquid holdings, to meet your near-term income needs. Once you've done that, you can hold those assets that you don't need to fulfill near-term living expenses in progressively more aggressive investment vehicles.

Such a strategy helps ensure that you're taking money from your most stable pool of assets first, and therefore you won't have to withdraw from your higher-risk/higher-return accounts (for example, those that hold stocks or more-risky bonds) when your account is at a low ebb. That strategy also gives your stock assets, which have the potential for the highest long-term returns, more time to grow.

Here's how to use a total return "bucket" approach to meet your own in-retirement cash needs.

1. Determine the Pay Cheque You Need From Your Portfolio
If you're attempting to create the equivalent of a pay cheque from your portfolio, the first step is to gauge your income needs during retirement, either on an annual or a monthly basis. Start by tallying your total expenditures, then subtract steady sources of income that you can rely on, including National Insurance and pension income. What's left over is the amount that you'll need to extract from your portfolio each month or each year.

2. Make Sure Your Withdrawal Rate Is Sustainable
The next step is to evaluate whether your desired portfolio withdrawal amount is too large or just about right. Most financial planners consider a 4% annual withdrawal rate, combined with annual upward adjustments to accommodate inflation, a safe withdrawal amount. For another check, there are various online tools, such as this retirement planning tool, that can help you determine whether your current portfolio puts you on track to meet your retirement-income needs. (Just bear in mind that they often use fairly rosy return expectations for stocks.)

3. Put in Place a Short-Term Bucket Holding of at Least Two Years’ Worth of Living Expenses
Assuming your desired withdrawal rate is sustainable, set up a short-term bucket consisting of at least two years' worth of living expenses set aside in highly liquid (that is, current, savings, money market, and certificate of deposit) investments.

Where you hold these assets depends on where you are in retirement as well as where you're holding the bulk of your retirement savings. Being strategic about where you take withdrawals from can help you stretch out the tax-savings benefits from your tax-sheltered accounts.

4. Put It on Autopilot
Once you've identified where your cash will be coming from during the next few years, contact your financial-service provider to see if it can help automate your withdrawals, sending you the equivalent of a pay cheque at preset intervals. (Better yet, your firm should be able to deposit the pay cheque directly into your account.) The larger your fund company or brokerage firm, the more likely it is to offer such an option.

5. Other Important Tasks
In addition to getting your pay cheque plan up and running, it's important to periodically replenish your cash assets as they become depleted. Once you've set aside your cash position, put in place a plan to periodically refill your cash stake so that it always will cover at least two years' worth of living expenses. Plan to incorporate this step into your rebalancing process. Ideally, you'd fill up your most liquid bucket with proceeds from rebalancing-related sales or with money from your next most liquid pool of assets (for example, intermediate-term bonds).

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

About Author

Christine Benz

Christine Benz  is director of personal finance at Morningstar and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances.

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