You'll most likely spend your pre-retirement years accumulating assets through saving and investing. Once you hit retirement, the idea is to de-accumulate these assets in a way that will provide you with a cash flow that will more or less match your spending. Having assets during retirement is a great thing, but it you can't effectively draw on your wealth to satisfy your spending in retirement, it won't adequately serve your retirement needs. Let's look at how best to manage those assets for the years when you're no longer working.
When it comes to generating cash flow, you typically seek out investments such as bonds, annuities, or preferred dividends; these types of investments will provide income in the form of interest, dividends, or term payouts. Assets that don't serve this particular income-generating need include collectibles, precious metals, and real estate, all of which are primarily focused on value appreciation. The point of planning for retirement is to figure out a way to bring money in when you're no longer working; any well-constructed retirement plan will focus on a cash flow that satisfies spending. This inflow of money is expected to be consistent and reliable.
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To effectively position your portfolio to address retirement income needs, you should create two sub-portfolios. The first is the floor portfolio, which focuses on providing necessary income. The second is the upside portfolio, which is an investment-oriented portfolio that seeks to capture the gains and positive performance in the stock market.
"Floor" and "upside" were coined by the Retirement Income Industry Association and deal with two different types of risk-management techniques that address your two types of spending: essential spending and discretionary spending. The idea is that the floor portfolio satisfies your essential spending with a predictable cash flow, while the upside portfolio (in the event of positive market performance) will satisfy your discretionary spending.
The floor portfolio deals with the most basic income requirement during retirement and should be your primary retirement planning focus. Once you project your spending habits in retirement, you can arrive at a basic income figure. Accurately projecting spending needs will mostly depend on you to figure out what your lifestyle will most likely be like in retirement, and the minimum amount you'll need to fund that lifestyle (in other words, essential spending). The floor portfolio is a segment of your overall retirement portfolio and will consist of products designed to provide consistent and reliable cash flow during your retirement years. Such products could be bonds, annuities, pensions, and other streams of cash flow you can expect to have claim on in retirement.
Once we have your floor portfolio, we then create an upside portfolio in the hopes of capturing the positive performance you'd normally see with riskier investments such as stocks, high-yield debt, and alternative investments. Don't depend on any yield from this portfolio for funding any part of your income requirements during retirement. Instead, reserve it for your non-essential aspirations such as luxury purchases, vacations, and other types of discretionary spending.
The key is to refocus your retirement planning efforts with an approach that emphasizes cash flow over account balances. Once you commit yourself to this approach, it all comes down to structuring your retirement portfolio accordingly and committing to a specified drawdown plan that provides you with needed income. Through prudent investing and risk management, we use both the floor portfolio and upside portfolio to give ourselves the best chance of achieving a financially secure and fruitful retirement.
The article Forget About Your Net Worth: In Retirement, It's All About Cash Flow originally appeared on Fool.com.
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