Is a portfolio worth $500,000 a lot of money for retirement? How about $1 million? What if you’ve saved $5 million? I get asked this a lot, and I find it helps to reframe the question: Is $2,000 a month a lot of money? What about $5,000 a month? Or $10,000?
When you look at it this way, you probably already know your answer. That’s because we generally conceive of wealth in terms of current income and not assets. Think about it: We pay income taxes and see our tax withholding on every pay stub, and we routinely deal with monthly bills and expenses that must be paid with current income.
Clearly, the answer to the question above about whether $500,000, $1 million, or $5 million is “a lot” of money for retirement depends on how much income you need the portfolio to generate. By “income” I mean how much cash does the portfolio need to provide you on a monthly basis in order for you to pay your bills. Interestingly, people who retire on a pension and social security don’t have to worry about their portfolio generating income. It just comes every month, like clockwork. Folks who retire on a pension don’t worry about the size of the pension fund of the company they retired from. They just deposit the check and continue to worry about other, more important matters. (Note: This doesn’t mean they shouldn’t worry about their company pension plan…. Unfortunately most people are simply unaware.)
I recommend to clients that they think of their retirement income as a pension payment that is funded by their personal account. With the help of their advisor, they will determine the proper amount of monthly cash they need to live on. I usually suggest they have the monthly withdrawal direct deposited into their checking account so they don’t have to bother with it. If you want a quick rule of thumb, figure you can take about 4% to 5% of your portfolio as income each year. So a $500,000 portfolio will afford you an annual payout of $20,000 to $25,000 per year, or $1,666 to $2,083 per month. (Please check with your financial advisor about sustainable withdrawal rates to get the withdrawal rate that works in your individual situation.) Generally speaking, your job is to not spend more than your monthly portfolio payment plus whatever other sources of income you might have. Enjoy yourself. Spend your time thinking of creative ways to entertain the grandkids.
However, our job is a lot more complicated. We have to figure out exactly how to find the 4% to 5% of your portfolio value we will pay out to you during the year. The first thing you should note is that Pinnacle invests your money to earn the highest total return possible for the amount of risk you are willing to take. We don’t invest your money to generate current income. The income from the securities in your portfolio is counted as part of the portfolio’s total return. So if the income from your portfolio is 2% of the portfolio value, and the securities in your portfolio appreciate in value by 4%, then the total return of your portfolio is 6% (2% income plus 4% appreciation.) Pinnacle will use the income generated by the portfolio and/or sell the appreciated or depreciated securities in your portfolio, in order to pay you your monthly retirement distribution (or as I prefer to call it, your personal pension payment). This is an especially good thing, because in a world with very depressed interest rates, it’s almost impossible to invest in securities that drive enough income for you to live on your portfolio alone. And ‘reaching for yield’ by buying higher risk securities is often a major cause of catastrophic investment mistakes.
Once we determine how much monthly (or bi-monthly, or quarterly) income you need, your wealth manager works with you to decide which individual account(s) will be the source of your monthly income payments. In making this decision, your advisor will be considering a number of issues relevant to your income bracket. Clients are often surprised when their advisor recommends taking distributions from both taxable and tax-deferred accounts, because it is actually in your best interest to generate more rather than less taxable income to maximize your tax situation.
After we decide on the correct portfolio(s) to fund your withdrawal, we rely on software tools to make some sophisticated decisions in terms of selling securities. That’s correct: Turning assets into income typically involves selling securities, and the trick is to sell the right ones. We subscribe to a sophisticated computer program that is based on the general rule that it’s best to buy assets at low prices and sell them at high prices, and then make appropriate sell decisions to generate your most efficient retirement income. Here are four decision rules that are built into the program:
1. The yield, or current income, from the securities in your portfolio is not reinvested, but is ‘swept’ directly to the cash account in your portfolio. The software will recognize this additional cash as being available to fund your monthly retirement payment.
2. Securities to fund monthly payouts are sold based on how far they are from the target percentage in your portfolio model. So if you own a security that is 0.9% over its target weight, it will be sold before a different security that is only 0.3% over its target weight.
3. We can program specific rules for taxes into your individual retirement plan. For example, we can specify a limit to the amount of taxes we generate from selling transactions. Or we can create rules for limiting realized short-term capital gains. Clients have to balance the benefit of any custom rules they create against the possible cost of running their portfolio differently than Pinnacle’s model portfolio strategy. Our financial advisors are there to help advise on these tricky tax questions.
4. You can specify ‘back-up cash’ if you want to have an emergency fund of cash to fund monthly payouts. It isn’t recommended because it will ultimately reduce your portfolio total return, but those who feel better knowing that cash is available at all times to fund their monthly payment can do so.
Turning assets into income is an important part of any financial plan, and Pinnacle advisors can help you to turn this ‘straw into gold.’ After all, you get a portfolio statement every month from your custodian telling you how much you own in assets. But the money that shows up in your checking account each month is what you get to spend and enjoy!
