Managing your finances in retirement can be tricky business. High inflation, market crashes, and economic uncertainty can create discomfort and even panic for the retiree who is not prepared to withstand these financial forces. Diversification can provide you with a comfort level in retirement that will allow you to not only sleep at night, but also ride out difficult times without jumping from investment to investment trying to chase the latest “hot sector.”
A concept called “pools of money” can provide retirees with the level of income they expect without having to be concerned about market volatility. Pools of money means essentially having three types or “pools” of money on three different levels.
Here's how the concept works. Think of a lake that flows to a pond that then flows to a well. The large body of water is constantly feeding the smaller. We then get our drinking water from the well. So, too, can this flow be accomplished with our money.
The large lake, which is money that we do not need for 10 years or more, is a mixture of stocks, real estate, and commodities. These are all assets that have large fluctuations but also high returns over time. This pool pays dividends and provides us growth that historically outpaces inflation.
As dividends are paid from this pool, the money is placed in a pool of bonds. Bonds, like stocks, fluctuate in value, but are much less volatile and provide consistent interest payments. More importantly, high quality bonds tend to perform very well when stocks and the economy are performing poorly. This is the stable pool of the portfolio that will provide a consistent income, but will be subject to the pressure of inflation.
The last pool is cash. This pool contains assets that are safe and liquid. Cash provides complete principle protection of the account, but will almost certainly lose ground each year to inflation.
Each of these pools has its place. It is important for a retiree to know what his or her expenses will be. Assume a retiree has a need for $60,000 per year, but Social Security and their pension will cover half, or $30,000. The remaining $30,000 will need to be made up through the investment portfolio.
Using the pools of money concept, we want to make sure that the “well,” or first pool, has $60,000 in liquid accessible cash. This ensures that if the market or economy is experiencing rough times, we have enough guaranteed cash for two years.
The next pool, our pond, contains bonds. We want to maintain at least 8 years worth of living expenses in our bond pool. This means that $240,000 worth of bonds will provide us with the security of knowing that if the economy collapsed and the market fell, we would now have 10 years of income in very safe secure assets, not only providing us with a good night’s sleep, but also performing very well during the difficult period.
The final pool, our lake, has our much more volatile assets. These assets are purchased with the knowledge that we have bonds and cash to live off of if they decline dramatically in a protracted bear market. However, if these assets are performing well (which we expect most of the time) the money from this pool can be used to refill your cash and bond pool.
This system for financing retirement lets the majority of assets grow without the interference of panic. The retiree can sleep well at night knowing that he or she is shielded from market sell offs. Income is drawn first from the well which is then replenished by dividends and interest from the other two pools. As the well is depleted, the money is replaced by selling assets from either the pond or the lake, depending on which has performed best, stocks or bonds.
Sell into strength! You want to ensure that you are selling assets that have done well to build your cash reserve. This will provide you with the diversification and safety you require during retirement.