How to enjoy retirement while leaving a good nest egg for your children

These questions are more important than many retirees realize. Decisions about your capital, whether to use it or keep it for your heirs, can make a big difference in how retirees invest their money and, therefore, the degree of risk they must take later in life.

I asked Charlie Farrell, Managing Director in Denver at Beacon Pointe Advisors, if he could do some math and discuss what makes a portfolio sustainable later in life. Here are excerpts from our conversation:

WSJ: Are retirees currently seeking or embracing a particular type of portfolio?

Mr. FARREL: I think that retirement is above all a more comfortable lifestyle in its various forms. As the risks of things like health issues increase and we face the reality of reaching the end of our lives, most people would prefer more comfort or stability around their finances, if possible. In general, this means portfolios with lower volatility.

WSJ: How do you build a “comfortable” portfolio? And what does this have to do with whether or not you get the principal on retirement?

Mr. FARREL: How comfortable you can get in a wallet pretty much depends on two things: whether you’re willing to spend the capital, and whether you control what I’ll call your personal inflation rate. If you’re ok with spending the principal – in other words, you don’t have a specific goal of leaving an inheritance for children or charity, and you just leave what’s left – and if you’re in control your personal inflation rate, you have much more flexibility to design a less volatile portfolio.

WSJ: How do you determine your “personal inflation rate”? And how do you control it?

Mr. FARREL: You can add up everything you spent in one year, then add up everything you spent the next year and compare the numbers. But a more practical approach is to manage your money according to a personal inflation rate that you choose. In other words, you spend within a specific budget and limit your personal rate to a certain percentage.

Let’s say inflation is 8% and you want to cap your inflation rate at 5%. In this case, you would spend no more than 5% more than what you spent monthly in the future. That way, you’ll be forced to manage your money around that number and make the necessary cost and quality trade-offs to hit that number.

WSJ: What are some of the trade-offs?

Mr. FARREL: Let’s say you spend $120,000 a year, but only $50,000 of that amount is spent on utilities, health care, taxes, insurance, and home maintenance. The rest is discretionary: leisure, travel, hobbies, etc. There’s not much you can do, say, for your car insurance. But you can make different choices regarding discretionary spending.

The point is to experiment with what you do and see if you can control inflation in retirement and still enjoy life. For example, you might want to buy an expensive car, but you decide to buy a more modest model. If you can do this, if you can control your personal inflation rate and maybe even reduce it, it reduces the pressure to increase the annual withdrawals from your nest egg. And that means you need less return to make your savings last as long as you do.

Historically, the toughest cycles for retirees have been those with high inflation and plummeting or stagnant markets – basically what we have today. If it only lasts a year or two, that’s okay. But if it drags on, it’s going to be a bigger challenge.

WSJ: Let’s talk about returns. What kind of return would a couple need if they were willing to exploit their principal versus a couple who would like to preserve it?

Mr. FARREL: Let’s say you start with $1 million and withdraw 4%, or $40,000, per year and have no inflation or portfolio growth. The silver will last 25 years. So to get to 30, you only need about a 1.5% return on your portfolio, if inflation is 0%. If you move inflation to 2%, you’ll see that to reach 30 years you need a total return of about 3.5% (a return of 1.5% plus the inflation rate of 2% ). Move inflation to 3% and you can earn 30 years if your return is 4.5%, and so on.

So, a return of about 1.5% above inflation will allow silver to last 30 years. It’s on paper, of course, but it gives you a basic idea of ​​how much extra performance you need. It’s not too much, actually, if you’re okay with spending the principal over time.

WSJ: And what about the couple who want to preserve the principal?

Mr. FARREL: Here you would need about 3% to 3.5% above inflation, with inflation between 2% and 4%. Let’s say your personal inflation rate is 2%. In this case, you would need a return of around 5% to 5.5%. While that doesn’t seem like much, you’ll probably need to allocate a lot more to stocks to try and achieve that return.

If you assume a bond yield of 3% and a stock yield of 6%, you would need just over 80% of your money in stocks to achieve a portfolio return of 5.5%. But to achieve a 3.5% return, you would only need about 30% equity. So the desire to conserve capital makes a big difference in the level of risk you might take.

WSJ: It sounds simple.

Mr. FARREL: Well, those are spreadsheet assumptions and of course the real world is a lot messier. Who knows what returns will be in the future. But if you need more returns, you’ll have to hold more stocks, which increases volatility and uncertainty and therefore generally increases discomfort.

So if you don’t mind the possibility of consuming the capital over time and if you can control your personal inflation rate, you can be more conservative and, therefore, more comfortable. It’s really about what matters most to you.

About Nicole Harmon

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