Most people have retirement planning all wrong. They think it’s about accumulating enough to reach a “magic number” on a balance sheet, or proper asset allocation for their investments, or knowing exactly how much of their savings to withdraw so they’ll have enough income to live on. After all, experts have preached those messages for decades.
Yes, it used to be about those things. But everything has changed.
As I explain in my new book, The Big Retirement Risk: Running Out of Money Before You Run Out of Time, the path to a successful retirement these days means devising a system for regular, predictable, sustainable cash flow. I call it “Lifestyle Driven Investing™.
Whether you are retired or getting ready to retire, it's important that you learn how to match your investments to the cash flow you will need. Rather than focusing on a “magic number,” which can go poof in a bad market, you should create an investment portfolio that reflects the reality of your lifestyle. Here’s how:
Your House of Security
First, you have to design your House of Security. A house begins with a foundation, and in this case that's your basic retirement needs — the elements of a reasonable lifestyle. They include food, shelter, health insurance, utilities and other essentials.
Now project how much annual cash flow you will need to sustain those essentials in retirement. Let’s say the number is $50,000. Then estimate how much you’ll receive annually from income you can count on, such as pensions and Social Security. Let’s say that’s $30,000. In that case, the difference between your basic needs and this expected income would be $20,000.
The Importance of 'Lifestyle Investments'
As soon as you can, you should begin funding that $20,000 shortfall with what I call “lifestyle investments.” These are investments that provide an income, either now or in the future, that’s safe or predictable or guaranteed.
Lifestyle investments might include individual bonds, annuities, real estate investment trusts (securities that are like stocks and buy real estate properties or mortgages), equipment leasing programs, or dividends from stocks.
Next, you go up the hierarchy in your House of Security and calculate how much money you’ll require for your wants. These might be nonessential expenses such as Internet, cable, dining out, clothing, gifts and even country club memberships. These are items you could live without if you couldn't afford them, but you want to have.
Let’s say the annual total cost of your wants is another $20,000. Assuming an annual rate of return of 4 to 6 percent, you might need between $333,333 and $500,000 in savings to come up with that $20,000. To that end, you’ll want to build a diversified portfolio of a slightly different variety of lifestyle investments — hybrid investments. These would be ones that could generate your anticipated returns fairly reliably, but they would be less safe or predictable or guaranteed as the investments you buy for your needs.
Examples of possible investments for your "wants" include some bonds, preferred stocks (dividend-paying investments combining characteristics of bonds and stocks), and equipment leasing programs (where investors’ money is pooled to buy equipment leased to businesses).
How to Fund Your Retirement 'Likes'
Finally, if you have additional money to be set aside for retirement, put that cash into investments that offer growth and capital appreciation. You can use these to pay for your “likes” — the next level of your House of Security. Your “likes” might include vacations, funding college education for grandchildren, a second home or a boat.
For these extras, you’ll want non-lifestyle investments, which means individual stocks, mutual funds or Exchange Traded Funds (ETFs), and possibly commodities. Such investments don’t offer guaranteed income, and they can be volatile. But since your needs and wants will already be funded with more reliable lifestyle investments, you can afford to take more risk with the remainder of your retirement savings.
What Many Investors Do Wrong
Many people make the mistake of using non-lifestyle investments, like stocks, to fund their retirement needs and wants. If those investments go down in value by, say, 40 percent — as they did in 2008 — retirees have two options: drastically reduce their lifestyles (which is difficult to do) or risk running out of money (which is even more undesirable).
These types of investments are suited to capital appreciation, not to sustaining a lifestyle in retirement.
To live the way you want after you retire, you must structure your investments to match your lifestyle expenses. With that in mind, you’ll need to determine the lifestyle you hope to have, estimate how much cash you’ll need to sustain it, and then find appropriate income-producing investments that will provide the necessary cash flow. Ideally, you’ll live off that income for the rest of your life and leave the principal to future generations.