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Averting retirement disaster

By Barbara Whelehan ·
Friday, March 2, 2012
Posted: 6 pm ET

Employers who offer traditional pension plans worry about risk. In fact, they ranked 18 risks in order of importance in the MetLife U.S. Pension Risk Behavior Index released this week. The top three risks were underfunding of liabilities, asset and liability mismatch, and asset allocation. According to the study, employers "no longer believe they can rely on traditional portfolio diversification alone to meet their future obligations."

What about individual investors?

Individuals approaching retirement are mostly worried about one risk: running out of money. They're often told that portfolio diversification is key to managing this risk. But relying on a balanced portfolio to preserve income in retirement is a crapshoot, says Erin Botsford in her book, "The Big Retirement Risk: Running Out of Money Before You Run Out of Time."

"The key to success during the distribution phase of life is to set up your investments to produce the amount of income you need to live your lifestyle," she told me. "What you don't want is for your income to be based on systematic withdrawals from a 'balanced portfolio' because with this method, your income changes, depending on the underlying value of your investments."

For example, according to conventional wisdom, a 4 percent withdrawal rate is considered safe and sustainable. Translated into round numbers, retirees could safely take withdrawals of $40,000 from a $1 million portfolio. But, says Botsford, "If the market falls and your investments are only worth $700,000 next year, then your income that year falls to $28,000. I don't know about you, but I can't plan my lifestyle based on wild swings like that."

How lifestyle investing works

Lifestyle investing is the focus of her book, which is a must-read for people in their 50s and up. In it, Botsford challenges such long-held beliefs as, "In the long term, the stock market always goes up." In fact, she points out in her book three lengthy periods during the 20th century when the market was flat: from 1906 to 1924 (18 years), from 1929 to 1954 (25 years) and from 1965 to 1982 (17 years). Taken together, that's 60 out of 100 years that the market didn't go up.

That's just one of several arguments Botsford makes to warn imminent retirees that if they follow conventional advice, they do so at their own peril. Another myth she dispels: Your net worth determines your lifestyle in retirement.

Hers is a pragmatic, risk-averse approach. To determine your retirement income needs, first analyze and break down your expenses into four categories according to your priorities:

  1. Needs (Basic necessities such as food, shelter, clothing and insurance).
  2. Wants (extras such as travel, hobbies and entertainment).
  3. Likes (vacation home, boat, etc.).
  4. Wishes (charitable giving, money for heirs).

From there, Botsford recommends investment products suitable for these categories. She calls these investments lifestyle, nonlifestyle and hybrid.

"Lifestyle investments are investments that produce an income that is either safe, predictable or guaranteed. These investments have the highest level of safety and are the most reliable," she explains.

Examples of lifestyle investments are different types of bonds (but pay attention to the interest rate environment before you buy), nonlisted, nontraded real estate investment trusts, and various types of annuities to provide insurance for your retirement portfolio. These investments should be used to produce income for basic needs.

"Nonlifestyle investments are pure growth opportunities that produce no income," she continues. These would be more speculative and would include domestic and international stocks and stock funds, exchange-traded funds, commodities, oil and gas, gold coins, etc. They would grow the portfolio to fund the "likes" and "wishes" categories described above.

In between are hybrid investments, which Botsford describes as a blend of lifestyle and nonlifestyle. "They may still produce an income, but they are not as safe, predictable or guaranteed as the lifestyle investments," Botsford says.

These might be managed bond portfolios, preferred stock, publicly traded real estate investment trusts, or REITs, covered calls, master limited partnerships and high dividend-paying stocks.

How can this type of retirement planning be put into practice? I asked Erin Botsford if she would design a portfolio for a couple in their mid-50s who plan to retire at 62. On Monday, I will post a blog that shows what she would do.


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