In my last post I suggested a simple, three-step strategy to determine how much income you need to produce each month to meet your monthly retirement income needs.
I called it my Bottom Line Retirement Income Strategy.
Step One: Determine your monthly income need in retirement.
Step Two: Add up your various sources of guaranteed income – social security, pensions, rental income, etc.
When you subtract your guaranteed income (the number you got in Step Two) from your monthly income need (Step One), you get what I call your “bottom line” – the amount of money you need every month in addition to your guaranteed income sources in order to meet your monthly income needs.
Step Three: Decide how you are going to meet your bottom line.
If you are like most people, putting all your money into bank CD’s probably isn’t the way to go, especially at today’s interest rates.
On the other hand, putting your life savings into the stock market may be more risky than you are comfortable with.
For most people, the third step in this Bottom Line Retirement Income Strategy is likely to be a balance of safe, fixed investments to meet your cash flow needs for the short run, and more volatile, income-producing, investments like stocks or stock mutual funds that can be invested with a longer time horizon.
What’s the right balance?
Generally, I tell people that any money they expect to spend in the next three to five years should probably NOT be invested in stocks. The risk to your principal is too great. Your stock portfolio needs time to recover when the market goes down.
A more conservative investor may want to stretch that time period out longer – maybe even up to ten years if you are really conservative.
While there are occasionally ten-year periods in which the stock market goes nowhere, lost decades are rare.
Odds are a well-diversified portfolio that includes small and large company stocks, U.S. and foreign stocks, and alternative investments like real estate and commodities will outperform cash, CD’s and other similar “safe” investments over a long period of time.
Use your bottom line to determine how much to invest the rest for the long-term.
If you read the previous blog post you know that the bottom line number in that example was $2,215 per month or $26,580 per year.
An aggressive investor might set aside enough money to cover 3 year’s worth of income needs or about $79,840 ($26,580 x 3) in that example. That way if the market declines, you can draw from cash or other safe, liquid investments while your stock portfolio has time to recover.
The rest of your retirement assets can be invested for the long-term.
A more conservative investor might feel comfortable setting aside as much as a decade’s worth of extra money to cover their cash flow needs or $265,800 in this example. While some may disagree, I believe a 10-year cash reserve should be more than sufficient to meet most people’s needs, especially when you factor in dividend and interest income you will be earning on your portfolio.
Most people, however, will fall somewhere in between these extremes. The right balance for you will depend on your risk tolerance, view of the markets and other factors.
The point is this: Figure out how much you need to spend each month. Set aside enough money to meet your monthly spending needs for a reasonable time. 3 years. 5 years. Even 10 years. Whatever it takes for you to be able to sleep at night. And invest the difference into a stock-based, income-generating portfolio that is more likely to grow over time.
This strategy may not beat the market every year, but it will help you to manage risk and allow you meet your income needs — now and into the future.