Retiring early means approaching your portfolio differently.
In your working life, you will likely focus on growing your wealth as quickly as possible. The earlier you want to retire, the sooner you will need this portfolio ready and the more you will need in it. You will have less time for this money to grow, so you’ll want to make the most of what you've got.
But you usually need more growth than usual in order to manage a longer retirement. An early retiree's portfolio will typically need stronger returns than normal to offset the additional years you're going to be drawing down on it.
So, managing your portfolio in early retirement takes some extra thought.
For example, say that you're 58 years old and plan on retiring at 59.5 (the earliest you can take money from a tax-advantaged account). That gives you about one year until retirement, with $890,000 currently in a retirement portfolio.
Here's how to think about it. You can also use this free tool to match with a fiduciary financial advisor if your interested in discussing the specifics of your situation with a professional.
Make a Social Security Strategy
The first question is how and when you will draw Social Security.
You can begin collecting full Social Security benefits at age 67. You can take benefits before that, starting as early as age 62, but you will permanently reduce those benefits for each month early that you begin collecting Social Security. At age 62, you would reduce your lifetime benefits by 30%, meaning that for every $1,000 you would have collected at age 67 you will collect $700 if you begin at age 62.
You can also delay taking benefits, waiting until as late as age 70. This will permanently increase your benefits for each month that you wait. At age 70, you would increase your lifetime benefits by 24%, meaning that for every $1,000 you would have collected at age 67 you will collect $1,240 if you begin at age 70.
Here you plan on retiring at age 59.5. This means that, barring other unmentioned income sources, you will spend several years drawing all of your income from your portfolio. Starting at age 62, it becomes a question of balance. You can start drawing Social Security at 62, and the earlier you do so the less pressure you will put on your portfolio in the short term. However, the earlier you draw Social Security the more you will rely on your portfolio in the long term because your benefits will be permanently reduced.
Here, for ease of use, we will assume the average retirement benefit of around $1,900, and that you wait until age 67 to take these payments. This means you will need 7.5 years of income drawn entirely from your portfolio, after which you can assume that $22,800 per year (inflation-adjusted) will come from Social Security.
Next, Consider Volatility, Longevity and Inflation
Especially for early retirees, there are three core risks you should anticipate for your nest egg: volatility, longevity and inflation. How you approach this will depend entirely on your approach to risk management. And it is essential to remember that this is about managing risk.
The usual phrase for this is "risk tolerance," but this is a misleading term. It frames risk is a matter of appetite and acceptance. But this is the attitude of a gambler, not a planner. Smart risk tolerance measures how well you can absorb and adapt to losses without having to change your long term strategy, not how much you're willing to roll the dice on losses.
For example, if your portfolio dips and you can reduce your spending, tap outside funds, or otherwise make adjustments to avoid liquidating important assets, that is good risk management. If you would need to sell off critical assets and principal in the face of a down-market, but you go ahead and invest in equities anyway, that is bad risk management.
The more you pursue growth, especially through capital-gains based income, the more you expose your portfolio to volatility and the more certain you can be that your portfolio will experience some down years. It's important to plan for that, and to invest more conservatively the fewer options you have for managing potential losses.
Yet, at the same time, you will likely need to invest for some growth in order to offset longevity risk and inflation. Longevity risk is the possibility that you will outlive your retirement savings. This is the risk that you will be 92 years old, physically unable to go back to work, with nothing left to live on but that $22,800 per year from Social Security.
Don't discount it. The median retiree will live to around age 87, and it's realistic that lifespans might improve over the next several decades. What's more, this number is just a median. Roughly half of all retirees will live into their late-80s and 90s. All told, it's smart to plan for a retirement that will take you to at least age 95. For a retirement that starts at age 59.5, we will round that off to 35 – 40 years of retirement.
During that time, just at the Federal Reserve's 2% benchmark, it is likely that prices will roughly double and the value of your dollars today will not be the same. To combat this, you will need to plan to increase your portfolio withdrawals by about 2% each year as well, otherwise your spending power will erode year-over-year. Combined, this means that your portfolio will need enough growth to generate 40 years of income and an annual 2% cost of living increase to your withdrawals.
Remember, a financial advisor can help you plan for various elements of your retirement. Speak with a financial advisor today.
Finally, How Should You Structure Your Investments?
This brings us to the central question, how should you structure your investments? What should you put this money in?
Part of this will depend on the tax status of your portfolio. If this is a standard pre-tax retirement account, like a 401(k) or a traditional IRA, you will pay income taxes on the money you withdraw from this account. You will need to plan on having your income reduced by those taxes. If this is a taxed portfolio, you will pay a combination of capital gains and income taxes on the money you withdraw from this account based on the underlying assets. If this is a Roth portfolio, though, like a Roth IRA or a Roth 401(k), you will pay no taxes at all. You can plan to withdraw less money from your portfolio because you will keep the entire amount withdrawn.
For the sake of example, we will assume this is a 401(k).
Then, estimate around how much you will have in your portfolio at time of retirement. If we assume a mixed-asset return of 8% over your remaining year before retirement, this might give you about $960,000 in your 401(k) at age 59.5.
From there, you can pursue investment strategies based on your income needs, growth targets and capacity for risk management. In general, the more you can adapt to losses, the more aggressive your approach can be. For example, say that you own your own home and have very limited fixed expenses. You can invest for more growth because, at need, you can cut your spending relatively easily during bear markets. On the other hand, say that you rent your home and have significant monthly medical bills and other expenses. You might need more conservative investments, because you have less ability to cut your spending in the face of losses.
There is some irony to the fact that higher expenses mean investing for less growth, but flexibility in this scenario may be high value.
With this in mind, here are three representative portfolio structures you might pursue. Remember, a financial advisor can help you navigate this and other nuances of retirement planning, including more detailed calculations with more assumptions.
All Corporate Bonds
- Average Yield: 5%
- Approximate annual return in first year of retirement, starting in one year: $46,725
The advantage to this portfolio is that it is an income investment, meaning that you will receive the 5% annual payments just for holding these bonds. If you can live comfortably off the portfolio's (relatively limited) annual return of $48,010, you can in theory live indefinitely off this portfolio. If you sell assets over time to increase the portfolio's returns, you might boost that income to around $55,000 for a 40 year retirement.
Mixed-Asset Portfolio (Half Bonds/Half Stocks)
- Average Return: 8%
- Approximate annual return in first year of retirement, starting in one year: $76,896
A portfolio that holds roughly half-and-half bonds and equities typically returns an average 8% per year. This is a common approach for investors seeking a balance of risk management and growth. If you can manage the volatility, this profile might generate a comfortable living for a 40 year retirement.
S&P 500 Portfolio (All Equities)
- Average Return: 11%
- Approximate annual return in first year of retirement, starting in one year: $108,669
Unsurprisingly, your most aggressive option is also the most lucrative. You might hold your entire portfolio in an S&P 500 index fund. The market returns an average 11% each year. However, you will (not might, will) have years when your portfolio generates less than this, and some when it even takes overall losses. You will need to manage your income for this. Most retirees can't absorb that kind of volatility, and so avoid this kind of investing.
How exactly you should structure your portfolio will depend a lot on your capacity to manage risk. The more you can adapt to volatility and losses, the more you can pursue the kind of growth that will offset your longevity risk and inflation.
Consider seeking guidance from a professional financial advisor to make sure you don’t miss vital elements of your retirement planning.
The Bottom Line
Structuring your portfolio in retirement requires real planning, and that's even more true for early retirees. The most important issue is that you need to hit the right balance between security and growth, so your money is there when you need it… and also so that there's enough of it.
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