A few years ago Morningstar ran an article about some things that people who are near retirement can do to to get ready. I liked it because it was pretty simple and straightforward. Here is the essence of that article, 5 steps that investors nearing retirement can take now.
Figure Out How Much Income You Will Need
Get out your checkbook, credit card statements–anything that tells you how you’re spending your money now. Think about how those expenses may change once you retire.
Do you plan to be physically active in retirement, participating in activities such as golf, travel, etc.? How much will these activities cost? What medical coverage will you have? Estimate what medical expenses you may have to cover out of pocket.
Do you expect any of your current expenses to fall in retirement? Maybe you’ll pay less for commuting, business attire, mortgage payments, or income taxes for example.
After you’ve listed your current expenses and estimated how they may change in retirement, you’ll know how much after tax income you’ll need. As you draw from tax-deferred accounts, you’ll also need to know how these expenses translate into pretax dollars. To get pretax dollars, divide your after tax number by one minus your tax rate.
Figure Out How Much Income Your Portfolio Must Generate
Consider the sources of annual income you’ll have once retired, such as pensions, Social Security, and other inflows. Add these amounts together, then subtract the total from pretax expenses in Step 1. The result: what you need to take from your portfolio each year.
Is that realistic? To find out, divide your pretax expenses by your portfolio’s total value. The number you get is your withdrawal rate.
Take Stock of Your Portfolio Now
Ask yourself a few questions about your current portfolio. First, how much is it paying today based on the interest (not capital gains) you’ve received during the past 12 months? Second, what sort of total return you’ve achieved over the past one-, three-, and five-year periods? Finally, figure out how much you have in cash, bonds, and stocks.
Adjust Your Asset Mix Accordingly
Be sure you have three years’ worth of expenses in cash and/or short-term bonds. If you know your expenses are covered, you’ll be more likely to ride out the rough patches in the stock market.
Then, consider how much exposure to the stock market you can live with. You’ll have to find a balance between the growth you need in your portfolio (to last your lifetime) and a risk level that still lets you sleep at night. In some cases that may mean rethinking your lifestyle and how much money you really need.
The balance of your portfolio should be invested primarily in intermediate-term high-quality bonds or bond funds. If you want further diversification, add smaller allocations to high-yield, inflation protected, or mortgage-backed bonds.
Don’t take on more risk than you need to. Start with a balanced portfolio of 50% stocks, and the rest in bonds and cash. Adjust up or down depending on your ability to withstand the volatility of the market. Most retirees find a comfort level somewhere between 40% and 65% of their portfolios in stocks. If your income needs are covered by another source (like a pension), you may be comfortable putting even more of your portfolio in stocks.
Adjust Your Portfolio
After you’ve figured out how you want to adjust your asset allocation, go back to Step 3 and re-evaluate your “new” portfolio’s income and total return. If you’ve structured your portfolio with a healthy cash pool, you can make needed principal redemptions from that. Then each year as you rebalance your portfolio, refill those cash reservoirs by weeding out poorer performers, realizing some of your gains or taking required IRA distributions.
These steps can take you a long way towards being prepared for the financial issues that retirees must deal with. Morningstar has a very robust retirement section on their website, so I would encourage you to go there if you are not quite sure how to do any of the above steps.