Generating Income From a $500,000 Portfolio
Throughout your career, the emphasis in retirement planning is on saving and investing. Once you retire, how do you make that pile of money last for 30 or 40 years? That's a much bigger conundrum.
Reconfiguring your investing strategy for retirement can be tricky. Unless you have the wealth of an oil magnate and can coast by on interest, gearing your portfolio for retirement is really a balancing act of growing investments, preserving capital and generating income.
Someone who retires at age 70 may live to be 90 or even 100 years old. Funding 30 nonworking years will take some cash and likely some risk to keep your portfolio around as long as you might be.
Bankrate asked three financial planners how they would design a portfolio to generate income for a 70-year-old retiree with a nest egg of $500,000 and no other source of income besides Social Security. According to the Social Security Administration, the average monthly benefit for retired workers at the beginning of 2011 was $1,177, which turns out to be an annual income of $14,124.
Balancing Income Needs With Reality
In an ideal scenario, retirees would never need to touch their principal. All of their income needs would be covered by interest payments, capital gains and dividends. But what happens if someone needs more earnings on an annual basis than their portfolio can provide?
In this hypothetical situation, the retiree has income needs totaling $50,000 per year.
That's a problem. For their portfolio to fund their yearly income needs, minus the Social Security payments, they would need to withdraw money at a rate of about 7% per year, which means they could come up short if they happen to live a long and healthy life.
"Of course there is no guarantee of the future, but it is reasonable to expect, based on historic data, that they might derive $25,000 a year in portfolio income," says Certified Financial Planner Robert Fragasso, chairman and CEO of Fragasso Financial Advisors in Pittsburgh.
That's assuming annual returns of 7% or 8% a year and withdrawals of no more than 5%.
"To draw off more than 5% risks eating principal, and I would not advise them to do that," he says.
There is only one other solution for retirees who cannot reduce their expenses: get a part-time job.
Read on to see how three financial advisers would design a portfolio to generate income from a $500,000 portfolio. All say that at least half the portfolio should be devoted to fixed income, and one recommends a hefty 23% allocation to alternative strategies.
Frank Germack CFA, Director of the Investment Department at Rehmann Financial in Troy, Mich.
Balancing income generation while mitigating risk is the main goal of a retirement portfolio of this size, says Frank Germack, director of the investment department at Rehmann Financial in Troy, Mich.
To protect against interest rate risk and inflation, he suggests diversifying fixed-income holdings.
But, "one thing that is a little bit harder to do with a portfolio of $500,000 is have adequate diversification," he says.
To that end he recommends using exchange-traded funds rather than individual securities.
"When you're buying smaller holdings, the markups can be a bit higher than creating the portfolio with different types of securities," Germack says.
What does he mean by markups? "Bonds are typically marked up when sold, meaning if a (bond) desk buys $50,000 bonds at a price of $100, they may re-offer to clients at a price of $101.50. The $1.50 reflects a markup."
Conversely, the bid/ask spread on an ETF is extremely low, as low as a penny in price, according to Germack. The bid/ask spread represents the difference between the price at which someone will sell the security and the price the buyer is willing to pay.
"ETFs offer improved liquidity, not to mention the diversification of hundreds of underlying holdings," he says.
He suggests even more diversification by holding international fixed-income investments.
"There was a time when international fixed income was considered opaque, difficult to value or of low quality. But we're seeing now that certain countries -- Australia, Canada, Korea -- offer attractive yields on their securities with very good quality," he says.
International holdings will provide income and can guard against the erosion of buying power from a falling dollar.
To manage interest rate risk and rising inflation, Germack recommends sticking with maturities in the middle of the yield curve for most of the bond holdings, or around five to seven years.
Dan Yu Managing director of EisnerAmper's Wealth Division and lead retirement expert
For retirees with $500,000 saved up, Dan Yu recommends diversifying with plenty of investments that will generate income. In fact, 70% of his portfolio consists of fixed-income investments.
"What we want to have is income streams from a diversified bond mutual fund. Due to the limited asset base, bond funds would be the best choice from a diversification standpoint. It should be understood that as interest rises, bond fund principal will suffer some decline," he says.
To minimize the damage from rising interest rates, investors should keep the average maturity of the bond fund under four years.
To avoid losing purchasing power due to inflation, he recommends allocating about 30% to equities. Using more aggressive investments will provide growth over time that should outstrip the rate of inflation. Of course, aggressive investments come with higher risk.
"One thing that could be added is a fixed annuity that pays out almost immediately or within 30 days after contributing the capital. That is one way to hedge the bet of them living a long life; at least there is a fixed income stream in addition to what Social Security provides," says Yu. He would allocate $50,000 to the annuity.
"An immediate fixed annuity for a 70-year-old should provide about $250 per month. This will vary a bit from company to company," he says.
The secret to finding a good annuity is getting good advice. Variable annuities tend to be trickier with a lot of hidden fees that are not in the client's best interest, says Yu.
In addition to the fixed annuity, Yu recommends using $100,000 to build a CD ladder.
As the CDs mature, the investor could evaluate his or her financial position and decide how much to roll back into the ladder.
In Yu's example, the retiree would get income from dividends and capital gains in addition to the interest from the CD ladder, bond fund and regular payments from the fixed annuity.
Robert Fragasso Certified Financial Planner, chairman and CEO of Fragasso Financial Advisors in Pittsburgh.
One of the most important aspects to consider when designing any portfolio is the ability of the client to stick with the program.
"If they start to flip-flop around, listening to street corner advisers, they may find themselves being led astray and losing capital. And they cannot afford to lose capital in this scenario," Fragasso says.
After the assets have been portioned out to investments, regular rebalancing will provide opportunities to scrape off some income.
"We always keep three months' at least, sometimes six, but we always keep three months' of income distributions in money market (funds)," Fragasso says.
"As we rebalance every quarter, we look at that reservoir of income payments and make sure it stays full. We do that when we liquidate to rebalance the portfolio," he says.
When rebalancing, investors sell portions of investments that have done well and buy more of positions that have floundered in order to bring the portfolio back in line with the original model.
It's not easy to successfully navigate a retirement income strategy, says Fragasso. Retirees should delegate this job to a trusted adviser who follows textbook financial planning.
"There are a lot of theories out there and a lot of them are untested, and some of them are going to be tested on you, the investor, maybe for the first time. You want a trusted adviser who is managing by textbook principles to guide you through this kind of a period," he says.