Most of us believe that we should reduce the riskiness of our portfolios when we retire. However, there is little agreement on exactly how to do this. One common rule of thumb is to use your age as your percentage in bonds. However, such fixed rules just don’t take into account people’s unique circumstances. I prefer a technique I call Cushioned Retirement Investing to reduce risk. This technique is based on the simple principle that you shouldn’t invest money you’ll need in the next 5 years in risky investments.
There is nothing magical about the 5-year threshold. More daring types may choose 3 years, and more conservative types may prefer 7 years. I’ll stick to the 5-year figure for this discussion.
The main idea is that you keep any money you’ll need in the next 5 years out of the main part of your portfolio. Because the main part of your portfolio only holds funds that will be there for 5+ years, it can stick to your preferred asset allocation for your entire life. If you have a 75/25 split between stocks and bonds through your working life, you can keep the same allocation in retirement, as long as you maintain 5 years of living expenses safely off to the side.
By “safely off to the side,” I mean something like a high-interest savings account (HISA), short-term government bonds, or guaranteed investments at a bank. However, any bonds or guaranteed investments have to come due before you need the money.
Making Yearly Adjustments
If you’re using cushioned retirement investing, you’d need to make adjustments to start each year. First decide how much money you’ll need over the next 5 years (taking into account inflation). Because of your spending over the past year, you’ll likely have only about 4 years of spending set aside. So, you’ll have to gather some cash from your portfolio, which will likely require some selling. Once you’ve got a full 5 years of spending set aside again, you’re set for another year.
The process of setting aside money actually starts well before retirement. When you’re 4 years away from retiring and you look at your needs over the next 5 years, you’ll need to set aside one year of spending somewhere safe. The following year, you’ll need to set aside another year of spending, and so on.
How Much Can I Spend?
Most of us have no grand plans for leaving a big inheritance and want to know how much we can spend in retirement. In a previous post I offered a spreadsheet that allows you to input information related to your situation and calculate the percentage of your portfolio you can spend each year. Keep in mind that the answers are only as good as the inputs you provide. There is also a page on the spreadsheet for doing the calculation in the other direction: figuring out how much you need to retire.
Some might object that it makes no sense to maintain the same asset allocation into retirement. Keep in mind that it is only what I call the main portfolio (excluding the cushion) that maintains the same asset allocation into retirement. If we look at total savings including both the main portfolio and the cushion, things are different.
In the 5 years leading up to retirement, the cushion builds. This lowers the volatility of the total savings. Further, as you draw down your main portfolio in retirement (as most people will), the cushion becomes a larger percentage of total savings, which lowers volatility further over time.
Other Applications of Cushioning
Cushioned retirement investing isn’t just for people looking to maximize spending. It can apply equally well to those who intend to leave an inheritance. If you’ve got a $5 million portfolio, but only spend $80,000 per year, you could just keep aside $400,000 and invest the rest with an asset allocation suitable for the long term.
In fact, the principles behind cushioned retirement investing can apply even before retirement. For example, they can be used for RESP investing. You could maintain your preferred asset allocation throughout the life of the RESP, except that starting 5 years before your children start post-secondary education, you begin setting aside some money in safe investments. The idea is that this safe money is still within the RESP until it gets spent, but you think of it as outside the main RESP holdings that are invested with your preferred asset allocation.
We can even think of an emergency fund as an extension of the idea of a 5-year cushion. The emergency fund is money that you might need over the next 5 years in case you have unexpected expenses or lose some income.
Cushioning can also apply to saving up for a house, cottage, or car. If you plan to buy in less than 5 years, the money should be kept safe.
Overall, I prefer cushioned retirement investing to hand-wavy advice on how to adjust your asset allocation as you enter retirement. A side benefit is that the concept of cushioning is general enough to apply to many other aspects of financial life as well.