Last Updated Jul 7, 2010 11:04 AM EDT
One way to prepare for such an occurrence -- what I like to call a recession-proof strategy -- is to withdraw just interest and dividends from a balanced portfolio of stocks and bonds to pay for your living expenses. I suggest you consider an asset allocation of no more than two-thirds in stocks, to protect against market downturns, but no less than one-third in stocks, to protect against future inflation.
In today's environment, this asset allocation will generate an annual income from dividends and interest of about 3% to 4% of your retirement savings, depending on your specific asset allocation and the emphasis on dividend-paying stocks. The 3% figure corresponds with a higher allocation to stocks, while the 4% figure corresponds with a higher allocation to bonds. The reason is that the dividend yield on stocks is usually lower than the interest rate payable on bonds, so portfolios with higher allocations to stocks usually have a lower total payout compared to portfolios with higher allocations to bonds.
Warning: Don't try to maximize your investment income, by picking either stocks that pay the highest dividends or bonds that pay the highest interest. These investments may be with struggling companies that are on the verge of reducing their payouts. Go for quality.
The retirement income strategy advocated here has three advantages:
- Since you aren't withdrawing principal, you have a very high likelihood of not outliving your retirement savings.
- For the same reason, you'll most likely be able to leave a monetary legacy to your children or charities.
- You have the flexibility to adjust to a different drawdown strategy as you age or if your financial situation changes.
Then, when you're no longer able to work, you can increase your retirement income by withdrawing principal or buying an immediate annuity, or some combination of these two strategies. The goal of the balanced asset allocation is to achieve some growth in your principal during the time when you're drawing just interest and dividends, so that you'll have more in retirement savings when you begin drawing down principal. This reveals another advantage of this strategy: It enables you to reduce the period over which you're withdrawing principal.
You can use the 3% or 4% payout rates to estimate how much retirement income you need to generate a given amount of income. For example, suppose you need $20,000 per year to supplement Social Security and other retirement income. If your investment earnings rate is 3% per year, you'll need about 33.3 times $20,000, or about $666,000 in retirement savings, to generate an income of $20,000 per year. If you're earning 4% per year, you'll need 25 times $20,000, or $500,000 in retirement savings, to generate $20,000 per year. (For the mathematically curious among you, the 33.3 multiplier is 100 divided by 3, and the 25 multiplier is 100 divided by 4.)
My next post will analyze how you would have fared if you had used this strategy during the "lost" decade from 2000 to 2009, which contained two of the crashes described above.
You can learn about other strategies to help protect your retirement security during economic downturns with my book, Recession-Proof Your Retirement Years: Simple Retirement Planning Strategies That Work Through Thick or Thin.