How to Manage your Retirement Income Sources

One of the most important aspects of retirement is how to fund your retirement. Your transition from accumulating wealth to withdrawing from your nest egg can be frightening and difficult. Retirement planning is all about managing cash flow and income versus expenses.

In this article we will teach you how to determine your current and necessary income, as well as how to consider subsequent decisions like tax implications. Most retirees do not like to think about spending down their retirement savings. We at Peak Financial Planning want to remind you that it is perfectly normal to feel some anxiety as you approach retirement.

Determine your Retirement Income Sources

Before you start making decisions and changing your future outcomes, you need to determine your current financial situation, including sources of retirement income. This is the first step in crafting your retirement plan.

We will list the common retirement income sources that you should consider as you approach retirement. In an ideal world, you have high benefits coming from guaranteed sources, like Social Security or pensions. Following that, you would withdraw from investments to bridge any gaps that may exist between your guaranteed income and desired level of spending.

Social Security

If you don't have much guaranteed income when you retire, the biggest decision you make in retirement is when to claim Social Security Benefits. Without these forms of guaranteed income, you are dependent upon Required Portfolio Income, which we call RPI. Your RPI is how much income you need to withdraw from investments to support your living expenses. You must keep in mind that your Social Security amounts depend on when you file for your income.

You can take reduced benefits at 62, wait until you're eligible to receive your full benefits—between age 66 and 67—or delay your income to qualify for a larger amount. Traditional advice tells you to wait for full benefits. In most cases this is the best decision. However, claiming earlier may be smarter for you if you have no other income to supplement your essential expenses.

The Social Security Administration has these helpful links to calculate your monthly income based on your own situation and information about filing.

• Find Your Full Retirement Age

• Social Security Retirement Planner

You can also decide whether to claim individual values or spousal benefits. If you and your spouse both had high incomes and contributed to Social Security during your working years you will likely claim individual records. If one spouse earned significantly more than another, you can claim based on the higher earners record.

When eligible for both individual and spousal benefits, the Social Security Administration will pay the lower earning spouse based on their individual record before spousal benefits start. Think of this like a marginal income tax bracket. The first portion of your income is taxed at a lower rate, and the remaining dollars will be taxed at a higher rate. If your spousal benefits are higher than your own retirement benefit, you will receive a combination of benefits equaling the higher spouse's benefits.

COLAs Help You Outpace Inflation

There are increases in Social Security benefits each year known as cost-of-living adjustments, or COLA. This is in place to help you keep up with inflation. COLAs became an automatic yearly increase in 1975.

Keep these in mind when you account for income in your retirement plans.

Employer Retirement Plans

Employer plans can be a highly valuable source of income in retirement. These make up some of the guaranteed income that minimizes your portfolio withdrawals.

A defined benefit plan ensures a fixed monthly payment for eligible employees, compared to defined contribution plans (like 401(k)s), where payments vary.

Some contributions will give you deductions on your tax return, deducting the contribution and creating tax deferred income. Some plans allow post-tax Roth contributions, providing tax-free income in retirement.

Defined Benefit Plans

Employees typically need to work for a specific period before becoming eligible for defined benefits. Your payments will depend on multiple factors, often including years of employment, average salary, or highest earning years. With these plans, employers bear the responsibility for managing investments and guaranteeing specific benefit amounts.

Oftentimes your spouse is entitled to some of your pension. The typical amount is 50 percent of monthly payment, but you may be able to increase the survivor benefit. If you want to remove your spouse as a beneficiary, your spouse must sign a written consent form waiving rights to this income.

Government employees have their own set of extra rules and guidelines. For example government employees might have to contribute using after tax dollars. Employees may be able to receive their pensions after a set period—such as 20 or 30 years—no matter how old they are.

Public employee pensions and military benefits tend to be adjusted automatically for inflation using a COLA.

Some pensions are covered by the Pension Benefit Guaranty Corporation (PBGC). The government runs this sponsor of lost and ended plans. If you lose track of your pension or your employer plan runs into problems, seek help from the PBGC. You also can search for a pension on the PBGC's website.

Defined Contribution Plans

401(k)s, 403(b)s and 457s are the most common defined contribution plans. These come in many employers including government benefits.

You will likely get an employer match as well, up to a certain dollar amount or percentage of your contribution (because employers make mandatory contributions to meet IRS requirements).

Usually these allow you to make investment choices from a limited menu of options. This means that the investment performance is your responsibility, and the employer makes no guarantee to your account value.

Because these are majority funded by employees, you can get more of what you invest with a quicker vesting schedule. You are also often allowed to make rollovers to another defined contribution plan or IRA upon separation of service or retirement.

Make sure you take time to comparison shop. In most cases, you do not need to make a snap decision with respect to your current employer’s retirement savings plan.

Portfolio Income

Your investments can be a supplemental source of income in retirement. Required Portfolio Income is the amount you'll need to cover living expenses like groceries or housing payments. Should you have excess investments, you can consider luxury spending for your personal goals or experiences with your loved ones.

First you should create a cash reserve for emergencies, generally three to six months of your basic expenses. You want to keep this cash in an accessible account like a money market fund. If you need to dip into these savings, you will want to replenish this cash reserve as soon as possible.

Once your safety net is secured, you want to consider investment choices that suit your risk appetite and income needs. Keep in mind that fixed income investments can also supplement your spending needs. Common examples are treasury ladders or dividend portfolios. Remember to always consult trustworthy financial advisors before making any important decisions regarding investments.

As you manage your investments you need to consider the tax implications. These include under withdrawal during Required Minimum Distribution (RMD) age. As of 2024 RMD's start at age 73. This means that you must take out a minimum amount from: profit-sharing plans, 401(k) plans, 403(b) plans, 457(b) plans, traditional IRAs and IRA-based plans such as SEPs, SARSEPs, and SIMPLE IRAs.

The RMD can be calculated online or with your financial advisor or CPA. The penalties for under withdrawals include 25% of amount not taken, or 10% if fixed within a specific grace period.

Home Sale

Selling your home is a major decision that needs financial and emotional consideration. Here are some details worth mentioning. Many retirees can gain a substantial sum of money from a home sale. Despite the amount of cash to consider, this is often a last resort. Home sales can also be a byproduct of desire to experience new things in retirement.

Remember that the proceeds of your sale must go towards any remaining mortgage balances. Your home value can also fluctuate with economic conditions including interest rates and local housing market volatility.

You also need to consider what your own personal goals are. Do you want to move to a new environment and get out of your comfort zone? Do you want to leave a house for your children or spouse? Do you have backup assets to cover your living expenses?

Pros include a large lump sum of cash to either invest or put towards a new home and a capital gains deduction ($250,000 for a single person and $500,000 for a married couple. Not owning a home also means cutting expenses of maintenance and property tax.

Cons include the emotional attachment to your home and the need to look for new housing. If you decide to downsize and buy a less expensive home, you will need to consider one of two options, purchasing outright or obtaining a mortgage on the new home.

The first option carries peace of mind, but it will tie up more of your money, leaving less to generate income. On the other hand, taking out a new mortgage means you must cover the cost of the mortgage month in and month out. If you go this route, it will be extremely important to manage your money to ensure it generates enough income to pay your mortgage.

Reverse Mortgage

Most americans over the age of 62 are eligible for a reverse mortgage allowing you to take cash in exchange for your built-up equity. Many companies will require you to own a larger portion of the equity in order to use these services. You can take a reverse mortgage from federally insured lenders, or private companies.

A reverse mortgage means you get paid to lower your equity over time, rather than you buying into the equity. Age, mortgage rate, and home value all contribute to the amount you are eligible for. The payments are also tax free because the payments are considered a loan. Reverse mortgages are an option for retirees who are in dire need of income, best saved when you are in dire need of income and have no plans to pass on your house to heirs. Remember once you take a reverse mortgage, your debt grows with each payment you receive. That debt must be repaid when you die, move out of the home, or sell the property.

You can take the proceeds as a single payment, a series of regular payments or a line of credit. An appealing feature of a reverse mortgage is that no income tax is due on the money you receive, because it’s a loan, not income.

Continuing to Work

One of the last resorts for retiree income is to continue working. Hopefully this is a choice made out of desire to work and feel fulfilled, rather than desperation for income. Remember that working while you are on Social Security benefits also affects your benefit amounts.

If you are under full retirement age, your benefits are reduced by 1 dollar for every 2 dollars earned over the annual limit ($22,320 in 2024). After full retirement age your benefits can't be reduced. Those earnings include any employment wages or self-employment income. Pensions, annuities, investment income, interest, and other government/military retirement pay aren't included.

If you pay social security tax you will also be contributing more to your social security record.

FAQ

When can I retire?

Determine how much income you need to live, and how much you will be earning from your stable sources. Create a budget of necessary and discretionary expenses, compared to your predicted earnings. Then plan out when you will want to claim social security benefits. All of these details will determine how early you can retire.

How do I produce income in retirement?

Retirement income is available from many sources. If your current income from predictable sources like retirement plans or social security is not enough, you have a few options. You will need to consider drawing down your retirement savings, getting a new job, or selling your home. Conduct some in depth research with financial advisors that you can trust before making a decision. That way you can avoid tax penalties and preserve your personal savings.

What do I invest in when I retire?

There is no universal answer to investment selection for retirees. You need to consider your own objectives and limitations. Investment choice depends on cash needs, time horizons, and your desires for your savings. Make sure to balance growth, income, and capital preservation.

Other Financial Planning Resources:

• How do Financial Advisors get paid?

• What is a Fee Only Fiduciary Financial Advisor?

• What is a Comprehensive Financial Plan?

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If you found the information above helpful, click here to watch my free Masterclass training that explains how you can increase your income in retirement by up to 30% and avoid running out of money in retirement.

Should you use a Model Portfolio in Retirement?

Should you use a Model Retirement Portfolio?

Portfolio management can be daunting for any investor. There are multiple nested decisions for each action that you take. For example: which models do you use? Do you invest in stocks or bonds? Where do you find model portfolios? How do you consider market conditions? Should you work with a financial professional? Out of a myriad of investment companies, which one do you work with? How do they come up with their models? What is portfolio rebalancing? How often should you rebalance your portfolio?

Models are one way to simplify investment management and can help you achieve your objectives. A model portfolio is a collection of one or multiple strategies that comprise your overall investment strategy. Just about everyone uses some form of investment portfolio, from individual investors to professional asset managers.

Most often, model portfolios are created by using mutual funds. Advantages to using mutual funds are lower entry costs to investing, lowering risk by adding diversification, and access to professional investment management. Disadvantages of mutual funds are expenses and fees, blanket investment advice, and potentially predatory investment managers.

This guide will help you determine how a model portfolio fits into your financial goals, and how to filter through a sea of models. The most common strategy is called asset allocation. We will discuss this and other common strategies below.

Income, Balanced and Growth Asset Allocation Models

Investing strategy is defined by investors goals. The 3 choices available are income, growth, and preservation of capital. You can also choose a balanced strategy that compromises amongst multiple goals. Income is seeking out current income in exchange for capital appreciation potential. This is usually done with bonds and dividend stocks. Growth is seeking capital appreciation in hopes of your investment values rising. This is often done by investing in high volatility stocks like technology and small cap companies. Preservation of capital is seeking to just hold the same worth over time without desiring income or growth. This is often done with cash or short-term bonds.

3 Easy Asset Allocation Portfolios

Before we describe asset allocation models, we want to make sure that you have a clear understanding of what asset allocation is. Asset allocation is one of the most popular methods of investing.

We can loosely define asset allocation as dividing your assets amongst a group of equities. This will be explained below but imagine multiple buckets of investments that all get different amounts of cash based on factors like volatility or the expected future of the economy.

There are multiple options, and we will give you some ideas but it's prudent to discuss the ones you're likely to see.

What is an Asset Allocation?

The most popular model utilizes a strategy called asset allocation. This strategy picks the "weights" for your portfolio based on asset classes. Let's break this down.

Portfolio weights are how much of your overall account or investable dollars, are given to any specific investment. Most investments are called securities. If you have $150,000 of investable dollars, and you put $50,000 each into 3 different investments, we can say each asset has a 33% weight.

The idea of asset class will depend on what you put your money into. If you chose those 3 investments to be an overall stock market mutual fund, bonds, and real estate or commodities, then they would all be different asset classes.

What about Portfolio Rebalancing?

Rebalancing your portfolio is reallocating your asset weightings based on either personal or market circumstances. Using the previous scenario, let's imagine that the stock market has gone on a spectacular bull run, just like the one that we see right now, in March of 2024. The mutual fund, for example SPY, which tracks the S&P 500 index, has risen in value. What was once $50,000 is now worth $100,000. If your other two investments stay at their original value, then that stock market fund is now $100,000 out of $200,000 total. That means that the fund is at a weight of 50% of your account.

Regardless of your model portfolio, something any wise investor will remember is to rebalance their portfolio or change their models.

Should you choose to rebalance, you may have to account for taxes in a taxable brokerage account/ Most often a rebalance is when you sell profits from an inflated fund and reallocate the profit where you see fit. The decision depends on your strategy and the model that you seek to use at that current point in time. We recommend considering different strategies that shift with your own personal life.

The 60/40 Model Investment Portfolio

The 60/40 name comes from putting 60% of your account into stocks and 40% into bonds. Investors don't need particular expertise or previous investing experience to use this model. The 60/40 portfolio is a model meant to enhance diversification and create a safer portfolio that gives investors a balance of risk and capital preservation or fixed income. The focus here is lower risk and raise risk adjusted returns.

This model is marketed to deliver satisfying gains while minimizing the risk of equity markets with the safety of bonds. Unfortunately, the model doesn't always work as intended. Historical data can show that these model portfolios usually need specific advice for each individual client. Many investors use exchange traded funds (ETFs) to accomplish this, and big companies benefit from ETF models because of the fees associated with those traditional models.

Here we see the growth of a portfolio that’s comprised of two funds for a 60/40 split.

The Three-Fund Portfolio

The three fund portfolio is similar to 60/40 models. They are thought to have slightly more risk with the ability to achieve more returns. Three fund models are another of the most popular investment strategies. Typically you will see an investor choose a whole US stock market fund, a US or global bond fund, and a world stock market fund. The volatility is supposed to be minimized because many funds are supposedly well diversified. One problem that exists with these models is that an investment can occur between multiple funds.

You can achieve decent results from this kind of model, but you again lack truly personalized strategy. Future results can compensate for the generalized advice, if you can afford to endure unfavorable market conditions. Your strategy should never rely on one individual sector or investment. This is one problem with a portfolio like the three-fund model.

Here we see the growth of a portfolio that’s comprised of three funds representing the overall stock market, bond market, and international stock market.

100% Stock Portfolio

This model would have you only use 100% stocks. This can be accomplished with different methods, for example sector rotation between stocks in industries like tech or consumer essentials. Regardless of the tactics, 100% stock models don't use bonds. Typically this model relates to buy and hold investors who use a strategy such as only one mutual fund that follows the broad "stock market". In more detail, only using one investment like VTI, SPY, or IVV. Each security listed here is a market capitalization weighted fund. These are 100% correlated to market conditions because the most popular stocks with highest growth potential also means bearing the highest risk.

As of late, many investors are also using 100% stock portfolios to substitute for traditional fixed income models, by investing in only dividend producers. This kind of asset allocation model is often frowned upon for not incorporating common elements of risk reduction such as bonds.

Here we see the growth of a portfolio only made of a 100% overall stock market ETF.

The Problem with Asset Allocation Models

In the chart above, the worst dip in the S&P 500 is a 22.34% decline. At this point the retail investor portfolio was down 37.29%. The worst for retail investors is a 39.54% decline. At this point the S&P 500 was down only 17.99%.

Asset allocation as an investment strategy isn't the absolute worst method of investing. It comes with its own set of tradeoffs, as does any investment strategy.

Here is a deep dive on the pros and cons of asset allocation models:

They Simplify Decision Making

The average investor doesn't have significant expertise in the world of investing. We've had many conversations with clients and prospects from all walks of life. Some desire a closer look at the research, understanding, and focus that comes with professionally managed assets. Others decline the investment management learning process because they simply seek a professional to delegate to or self-manage investments with as much ease as possible. This is where model portfolios help the most.

Simplicity is the biggest advantage that asset allocations offer. For investors seeking simplicity, asset allocation is a fine method. As described, you aim for X percentage of value into each chosen asset class. You don't have to stress about nitpicking assets. The only factors to choose between are which asset allocation template you use, and how often to rebalance if at all.

Keep in mind that if you never rebalance your portfolio you will stray from the original allocation, and your model is no longer what you are invested in.

They Aren't Dynamic

While you can adjust your model, asset allocation is often very flat. Many investment advisors will typically use something like a 60% stock to 40% bond portfolio and leave investors in something which is propagated as zero risk. They may also leave rebalancing for each year's end, which ignores clients' life changes. Risk doesn't wait to increase only once per year. It can spike within the market very suddenly.

Investing is much more complex than this. It doesn't make sense to use a tool that is actually shown by data to hurt clients. Why use an investment strategy that doesn't deliver the expected outcome? Historical data shows that traditional asset allocation models often have very poor risk adjusted returns.

They Encourage Laziness

Many individuals will come across a model portfolio with the aim to reduce costs, chase high returns, or other factors of influence. This alone is the main benefit and importance of attempting to create a model. No problem inherently exists with that. A problem is only created when investors who lack confidence or education then use that model to ignore decision making. Specifically, lazy financial advisors who only care about annuitizing income from their clients without putting in genuine effort to give clients an optimal investment strategy. Why leave clients in static portfolios rather than adjust strategy with life changes? Big business often ignores the individual needs of clients and prefer to place clients in an asset allocation model. This is because they raise cash by collecting fees for selling and owning funds. Investment advisors often get a bad reputation for ignoring their clients' needs and using blanket recommendations despite changing market conditions.

How to Find an Advisor you can Trust

There will almost always be a conflict of interest in that financial advisors and planners have a personal benefit of managing your money. With that in mind, you can seek out a fiduciary who is legally obligated to act in your best interests. Here is a free guide to helpful questions you can ask when interviewing a financial advisor. The accuracy of their answers compared to their marketing data will be one gauge to help measure reliability. Another way to filter for trustworthy advisors is to learn about their business mission and their philosophies regarding investment management.

You will always want to find a financial planner or advisor whose values align closely with your own. This rings true with matters like cash flow and also desire to utilize risk in portfolios. Their models should not contain risk far outside of the bounds your financial plan can tolerate.

How much does a model portfolio cost?

A model portfolio can be completely free! Just remember that free does not mean worthless. You may also end up paying more than the value you gain from a poorly devised strategy. All investors' portfolios should be based upon data containing relevant metrics. Don't choose your investment plans off of advertised return alone. Remember that models may only boast their best performing statistics and gloss over other key data. Please consider your own personal financial goals and how they fit into your financial plan before utilizing a model portfolio.

FAQ

What are Model Portfolios?

Model portfolios are a way for investment to be simplified. Models simplify strategy by helping to select each investment for a portfolio. This is wonderful for any investor who doesn't have the time, knowledge or temperament to manage their own investments. Your investment performance can be more or less consequential depending upon your reliance on your investment portfolio. Not all models are made for everyone and while some are marketed as one size fits all, your strategy should always be based on your individual needs whenever possible.

Should I use an Asset Allocation Model?

You should consider using an asset allocation model if you are an investor who lacks the ability to refine your investment portfolio in fine detail. If you need an easy answer to investment selection, asset allocation may benefit you quite nicely. Just be aware of the tradeoffs you face, simplification in exchange for advice that wasn't made for you specifically.

Will my Strategy Work in any Market?

All investors should understand that there is always risk in investing. Everyone has bad picks, and no investment is 100% bear market proof. Well-crafted strategy can minimize risk during adverse market conditions, but you will likely need to change the original strategy to maximize your protection.

Other Financial Planning Resources:

• How do Financial Advisors get paid?

• What is a Fee Only Fiduciary Financial Advisor?

• What is a Comprehensive Financial Plan?

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If you found the information above helpful, click here to watch my free Masterclass training that explains how you can increase your income in retirement by up to 30% and avoid running out of money in retirement.

What is Portfolio Rebalancing?

You may have heard friends or financial advisors mention their rebalanced portfolio and wondered "what is portfolio rebalancing?" or "how does it work?". In this guide we will seek to provide easy to follow education on what portfolio rebalancing is, so that you may rebalance your portfolio by the end of this article.

Portfolio rebalancing is performing the necessary trades in your investment portfolio back to the desired asset allocation. This means you sell overweight stocks or asset classes and put the proceeds into an underweighted security or asset class.

The most common reason to rebalance is to account for eventual portfolio drift that occurs when you aren't a day trader constantly adjusting your asset mix and actively managing your investments.

At Peak Financial Planning we seek to educate investors, specifically those within the Retirement Risk Zone. We define the Retirement Risk Zone as the 10 years on either side of your retirement. This is when your portfolio can have a dramatic effect on your retirement success.

Table of Contents:

1. Portfolio Rebalancing in Practice

2. Where Conventional Portfolio Rebalancing Wisdom Fails

3. Steps in the Rebalancing Process

4. How we Recommend Approaching Portfolio Rebalancing

5. Potential Tax Consequences

6. Other Portfolio Rebalancing Considerations

7. Frequently Asked Questions

Portfolio Rebalancing in Practice

Let's consider a hypothetical scenario that we have seen before:

For example, your target asset allocation is 60% stock and 40% bonds. At the time of writing, the stock market has had record performance, which may turn your portfolio value into 80% stocks and 20% bonds. The balance among asset classes is askew.

In order to rebalance your portfolio, you would sell that extra 20% of your account value that is held in stocks. Once the proceeds have settled, you can reinvest that cash in the other asset classes that have lowered in your portfolio weight, in this case bonds. This gets you back to the original allocation, hence rebalancing.

Portfolio Rebalancing Versus Tactical Asset Allocation

This is not to be confused with tactical asset allocation which involves changing your short-term investment strategy to accommodate your personal finance needs or attempting to capitalize on market fluctuations.

Tactical asset allocation means that you change your targeted allocation weights to serve a temporary purpose. Rebalancing is changing your current asset allocation back to the desired allocation set out in your investment strategy.

Think of clearing a messy canvas as opposed to getting a brand new one, or trying to get back to your normal goal weight after a vacation versus moving your goal weight because you have new desires based on new health goals.

Where Conventional Portfolio Rebalancing Wisdom Fails

The typical financial advisor leaves you with many unanswered questions. We have spoken with many people who have felt disgruntled and ignored by large financial services companies. Often advisors create a tangled web of obscure promises that leads to a lack of clear, decisive, and accountable actions.

There are many moving parts to rebalancing strategy which must be accounted for when you actually rebalance your portfolio. Should you follow the same path as everyone else, you can't expect to have exceptional results that beat the average performance.

Here are a few shortcomings with traditional rebalancing strategy:

Asset Class is the Most Important Factor

Asset allocation is not the only consideration with portfolio risk. We believe that the concept of asset allocation oversimplifies investing and inhibits the creation of ideal retirement circumstances. Oftentimes investors believe that a 3 fund or 5 fund portfolio is the best they can do.

That 3 or 5 fund portfolio's asset mix is usually a blend of mutual funds or ETFs (exchange traded funds) consisting of domestic stock, emerging market stocks, an aggregate bond index, and international stocks.

Using a standard asset allocation is better than not investing at all. However, it doesn't account for all market conditions and your nuanced individual needs.

Your Needs are Based on Your Life

Beyond a mix of specified weights on each asset class, popular rebalancing strategies often ignore the qualitative factors that make you who you are.

Individual risk tolerance needs to be considered. A standardized asset mix can't possibly accommodate what you need and your financial goals. Having a one size fits all strategy means that as market performance or your goals change, you're stuck with the original asset allocation and all of its inherent risk.

This is why you need a custom investment strategy that is tailored to your needs and goals. We account for your personal life with regards to your investment goals. If going to a financial consultant, seek a fiduciary that has legal obligation to put your interests first. Peak Financial Planning is a team of fee only fiduciary financial advisors who care about your retirement success.

Click here to schedule a free no obligation consultation with our Fee Only Fiduciary Financial Planning team.

What if you Need to Add or Remove Investment Positions Entirely?

Many proponents of steadfast asset allocation are too scared to alter their asset mix, and only go back and forth between their original asset allocation and whatever the portfolio value currently sits at.

This isn't a terrible strategy that is useless in entirety. But it doesn't give you flexibility to adjust your investing goals based on the new factors of your life. Things remain rigid and locked into the asset classes that you originally picked out. You may have 50% domestic stocks, 20% stock in emerging markets, and 30% of bond allocation. Should staggering bear markets come along and diminish all three portions of your asset allocation, you have nowhere to go.

This leads us to tell you don't be afraid of selling assets entirely. You are allowed to change your investment selection or adjust your target asset allocation. Keeping your portfolio consistent in each position for your investing tenure no matter the circumstances does not serve your best interest.

Your current portfolio may not be your best option when your financial goals change during declining markets. Especially during the Retirement Risk Zone because you are exceptionally vulnerable to factors like sequence of return risk.

Your portfolio's allocation may shift with your life changes or market fluctuations, which can be called rebalancing events. These are times where prudent investors will reevaluate their asset allocation and financial goals.

What do you do if too frequent? What do you do if too infrequent?

Rebalancing is better than doing nothing with your portfolio for your entire investment duration. Not rebalancing lets the market dictate risk because you will be stuck following the market wherever it goes, with no room for course correction.

That being said, there is no perfect answer to the question of how often should you rebalance. The goal is to pick a well balanced approach that is proactive, rather than reactive. Picking any period of time as a hard rule isn't always the best option. Using a set time horizon to always evaluate has its pros and cons.

Click here to schedule a free no obligation consultation with our Fee Only Fiduciary Financial Planning team.

Rebalancing Strategy

Here we will walk you through the two most common rebalancing strategies. You can think of those two as target allocation bands, or periodic/ calendar rebalancing.

Using Tolerance Bands to Drive Rebalancing

One of the most popular rebalancing strategies is to use weighted tolerance bands. This involves attaching limits to keep the portfolio close to the desired asset allocation in terms of worth as portfolio weights.

A more detailed explanation is to set guard rails for each position you hold in your investment portfolio based on the target allocation percentage of your portfolio's value. For example, you invest in ten ETF's that all constitute 10% of your portfolio as a whole. They might all constitute individual sectors of the market, or different asset classes. The dollar value of each will change as the market fluctuates, but your target allocation is 10% in each fund.

If one of those ten funds inflates in value to the point that they end up being worth 20% of your total portfolio value, then you would need to rebalance your portfolio to stick to the asset allocation goal of each fund being worth 10%.

You can think of rebalancing your portfolio as selling off overweight stocks and reentering another underweighted asset class. This may be lowering the amount of money in stock investments and increasing the amount of money in bond investments.

Another factor of avoiding excessive trades is minimizing transaction costs and high taxation. Depending on your rebalancing strategy transaction costs can take up much more of your proceeds than expected.

Periodic Rebalancing

A common question is how often should you rebalance your portfolio?

There is no definitive answer for every investor. The other side of the rebalancing token besides tolerance bands is balancing by period. You can think of this as picking a time frame which will automatically be part of your rebalancing events.

Another important factor to consider when using tolerance bands is the tax implications of trading positions. If you are using taxable accounts, each sale can incur tax liability, even if you don't have capital gains. If you are in a high income tax bracket you will want to minimize taxes from your investments which means even less frequent trading.

Frequently rebalancing means more transaction fees because you will be trading more often. Of course, you want to manage risk, but you will need to find a balance between micromanaging your portfolio and being completely hands off.

Annual rebalancing means adjusting your asset class and portfolio weights at the start or end of every year. Most people use this as an opportunity for going back to the original asset allocation once a year.

Quarterly rebalancing would be rebalancing every 3 months, which tracks more closely to a tactical asset allocation strategy.

Rebalancing once per quarter is a balance of "tactical and strategic investing" using traditional terms.

Click here to schedule a free no obligation consultation with our Fee Only Fiduciary Financial Planning team.

How we Recommend Approaching Portfolio Rebalancing

At Peak Financial Planning we believe that a hybrid of both periodic and bands strategies give the best outcome to investors when utilized together.

There is a very fine line between overly frequent rebalancing and minimizing portfolio drifts. While you don't want to stray too far from your target asset allocation, you also don't want to be neurotic about your investments.

We use quarterly rebalancing as a guard rail, while actively checking for important life changes or economic events. We account for personal risk tolerance with regards to dynamic life events. Should an investor be approaching retirement, we may downshift their risk levels depending on required portfolio income and Social Security claiming age.

Each person has differing circumstances, but we also assign tolerance bands to keep things close to the target allocation.

This allows us to achieve the best mix of letting winners ride within a certain specified tolerance to allow for capital gains, while maintaining the flexibility for strategies such as tax loss harvesting.

How does Rebalancing your Portfolio Affect Investment Goals?

Portfolio rebalancing helps facilitate risk management with your investment goals. This takes shape in the reduction of more aggressive investments to recreate a more balanced portfolio, usually a reduction of your equity portion from investments like international stocks.

When you rebalance your portfolio, you also gain additional help in reducing emotional impact on your investment portfolio in order to safely manage risk.

Many investors often get ensnared in the trap of impulsive and emotional decision making. This comes from a place of fear rather than education. Using a systematic rebalancing strategy can help regulate emotions and remind us that there is a goal in sight.

Nobody likes to see down positions in their portfolio. That being said, rebalancing helps losing positions turn into opportunities. Tax loss harvesting is an example of this for anyone who has locked in capital gains.

With regards to tax loss harvesting and active maintenance, we like to remind investors to be proactive in trimming losers. Bear markets don't have to be entirely bad because they can help you safely extract tax free gains that were previously locked in.

Our objective is to teach those who seek help investing for retirement success.

Steps in the Rebalancing Process

Rebalancing your portfolio doesn't have to be complicated. Your target allocation is a guideline not a hard rule. Do not be constricted by past performance or asset class percentages. Having 50% in the S&P 500, 10% in emerging market stocks and 40% in bonds is not a full proof strategy.

When you rebalance your portfolio you can use a simple checklist that follows a similar structure each time:

1. Evaluate what's going on in your life and what risks you face in the near future.

2. Assess your current allocation compared to your personal risk tolerance.

3. Determine where you want your investments to go for your personal time horizon (think of your short and long term goals)

4. Are there any changes to your goals that need to be accounted for? (think new life events such as a child's college funding, or moving to a new city)

5. Decide what positions need to be enlarged or trimmed down based on a well-educated opinion, such as your trustworthy financial advisor.

When you decide to rebalance or change your portfolio, you MUST remember, historical data is a guideline not a rule. Previous performance does help guide decisions, but you should never follow it as a guarantee of what to expect in the future.

Click here to schedule a free no obligation consultation with our Fee Only Fiduciary Financial Planning team.

Potential Tax Consequences

You need to consider the tax effects of your investment decisions, especially if you are in retirement, as taxes will be one of your biggest expenses. One of the biggest factors in your tax planning is the type of account you are managing. A taxable account will incur tax liability when selling for a gain, but IRA's and tax deferred accounts will not incur tax until you withdraw funds.

Type of account matters

Because taxable accounts will create tax consequence after sales, you are somewhat limited to the frequency with which you can rebalance them. Overly frequent rebalancing in a taxable account can lead to a severely inflated tax bill. That being said there are steps you can take to mitigate your tax liability.

You can use tax loss harvesting as an opportunity or vehicle to rebalance your portfolio. Tax loss harvesting is when you sell positions that have unrealized losses, to balance out gains you've taken from your taxable account. This is a strategy that helps you extract gains from your portfolio without having to pay income tax. There are rules you have to account for however, such as long term losses must first be used against long term gains.

While you should be aware of your tax situation, don't avoid rebalancing entirely in taxable accounts. If you never rebalance your portfolio, you will end up with locked in gains that you may not be ready to extract, which end up ruining diversification opportunities and making it difficult to navigate in the future.

Other Portfolio Rebalancing Considerations

There are multiple things you need to be aware of should you manage your own investments. This is a difficult endeavor that should not be taken lightly. Investment management takes years of practice and research to become skilled. Here is a breakdown of factors that don't get as much spotlight as they should when discussing investing.

Minimizing Taxes and Transaction Fees

You will need to accommodate transaction costs and looming tax bills when creating your rebalancing strategy. Each transaction may create tax liability or fees with the company that is holding your investments.

Individual asset class can also be a factor here. With funds, you must consider the class you are investing in. Class A funds will charge you an entry fee, class B funds will charge you a declining fee to exit your position, and class C will have both types of fees. Some stock investments are made to have low expenses, with much higher risk. Each type of bond can have different tax liability for interest and principal.

Make sure to thoroughly research your asset choices and how they fit into your personal situation. Remember that a blanket strategy can't possibly be the best choice for everyone who uses it.

Invest the Cash in your account

Many investors forget that a sale must be followed by a purchase unless you are planning to withdraw that cash soon. The only other time to wait on reinvestment is in anticipation of a drop in your chosen investment or asset class.

You will need to reinvest the newfound cash from any sale, or deposits of cash from an external account, to keep up with your investing goals. Otherwise, that cash will be eroded by inflation and racking up opportunity cost.

How Much Does It Cost to Rebalance a Portfolio?

The cost of rebalancing your portfolio will depend on which sales you make, market timing, and your investment goals. Selling positions can create fees or tax liability. The time you rebalance is important because it may change the asset class weights you shift to. Your personal goals will change what strategy you take and what you invest in.

There is no set answer for the cost of rebalancing a portfolio but you can choose when to rebalance based on your individual situation. The costs you face are your tax liability, opportunity cost, and whether or not you are closer to your goals.

What matters most is that you evaluate your cost and performance based upon your own needs. Every investor has a unique baseline and goals that shift with THEIR lives.

Click here to schedule a free no obligation consultation with our Fee Only Fiduciary Financial Planning team.

Frequently Asked Questions:

What are the Pros and Cons of Rebalancing:

The pros of rebalancing are managing your risk, having a strategy to help you decide when or how to take profits or losses, and stability in terms of emotional decisions. Shifting portfolio weightings helps lower risk in overconcentration of one asset. The ease of a rebalancing strategy can allow you to help make decisions with regard to timing, attachment to assets, or asset weighting.

The cons are potential taxes, automatic rebalancing when you aren't prepared, and the responsibilities that follow a rebalance. Sales should be made with consideration to future tax consequence. You also need to be aware of automatic trades should your rebalancing happen without manual approval. Research should also be done into what you invest in, and how to invest cash from sales made.

Does Portfolio Rebalancing Reduce Returns?

Rebalancing can affect returns, just like any investment decision. You can't predict future performance with 100% certainty, but you can prepare and make educated decisions. Rebalancing will ideally raise your returns by shifting into assets that will perform well.

The Bottom Line

Rebalancing strategies are beneficial for investors that don't plan to buy and hold an investment. Rebalancing will help anyone manage a portfolio whether it be performance or decision making. Whether or not you adapt your strategy may further affect performance but having a strategy in the first place helps establish guardrails to manage your investments.

Click here to schedule a free no obligation consultation with our Fee Only Fiduciary Financial Planning team.

Other Financial Planning Resources:

• How do Financial Advisors get paid?

• What is a Fee Only Fiduciary Financial Advisor?

• What is a Comprehensive Financial Plan?

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If you found the information above helpful, click here to watch my free Masterclass training that explains how you can increase your income in retirement by up to 30% and avoid running out of money in retirement.

The Retirement Risk Zone

Retirement Planning's Missing Phase - Don't Ignore This!

Retirement planning is often broken down into 2 phases: accumulation and distributions. Yet there is a gap in most planning. The third critical period is called the retirement risk zone. We focus on this forgotten third phase which constitutes the ten years before and after retiring.

The retirement risk zone is where you will face many obstacles that create stress or financial burden. This article will help clarify what to watch for, how to judge your own financial picture, and how to measure your own success.

Peak Financial Planning specializes in helping people in the retirement risk zone conquer their financial risks. These topics will be analyzed through the lens of our actual planning process that has helped over 30 retirees fulfill their retirement dreams.

Table of Contents

1. The 2 Phases of Conventional Retirement Planning

2. The Missing Phase of Retirement Plans - the Retirement Risk Zone

3. Cash Flow Planning During the Retirement Risk Zone

4. Retirement Income Planning During the Retirement Risk Zone

5. Tax Planning During the Retirement Risk Zone

6. Bringing it All to a Close

7. FAQ

The 2 Phases of Conventional Retirement Planning

Most people see retirement as just two phases: accumulation then distribution. Growing wealth and then spending it down.

Neither the accumulation nor distribution phase can be overlooked because both have significant impact on retirees. We will cover these two phases before exploring the missing third phase with the most risks.

The Accumulation Phase

The accumulation phase consists of your working years, more specifically when you begin to save and build wealth. This is the time to build an education alongside your savings.

The problem is that most people consider retirement an abstract and distant puzzle that doesn't enter line of sight until you are actually leaving the workforce. Traditional planning creates a blind contribution system that doesn't involve education.

You don't need to become an expert in day trading and IRS tax rules regarding savings plans but you do need to understand what works best for you. For example, how much your employer will match in contributions or what accounts to contribute to.

You typically see X percentage of an investor's salary going to a 401k or IRA from each check they receive. You not only need to save but you need to learn what you invest in and how it benefits your retirement goals.

The Distribution Phase

The distribution phase is when you leave the workforce and begin to draw from your savings.

This should be a peaceful time where you can relax and enjoy the benefits of your hard work. Unfortunately, few people practice careful planning until they're confronted by a swirling pool of decisions and questions that feels overwhelming.

How much do I have in portfolio assets? Where will I take distributions first? What are the tax consequences of each distribution? How do I navigate market downturns? These are just some of the questions that affect retirees.

Many scramble to find help through a financial advisor just before or after retirement. However, many advisors focus on churning fees and pushing an agenda that only benefits them, not the client.

If you find yourself in this crisis, you can reach out to Peak Financial Planning.
We are a team of fee only, fiduciary financial planners that are legally obligated to act in your best interest.

The Missing Phase of Retirement Plans - The Retirement Risk Zone

What most people do not consider are the years surrounding retirement. Some may avoid retirement planning out of fear or even ignorance, but this only harms you. It's ok to not know everything pertaining to savings, distributions, and taxes. But you will want to learn what you can before your retirement date.

When it comes to retirement what matters most are the years immediately before and after you've retired. This is because you have to account for the behaviors and income stream that will influence your new lifestyle.

Why the Retirement Risk Zone is the MOST Important Phase

The crux of the retirement risk zone is that you can’t go back in time. If you haven’t properly planned, you can be trapped in a position of fear and stress. One way this can manifest is you attempt retiring and then find yourself working a part time job because you’re unable to support your needs. The uncertainty of how much you spend, how much you need to earn, what’s happening with your retirement savings, and what you can and can’t afford will obstruct your life.

If you take the time to understand your perspective and how you behave with money, you can build a solid foundation for your financial future. Knowing what you are comfortable with and how you spend can create success. For example, understanding how much cash you need to feel safe, or your satisfactory quality of life creates a stable baseline.

In the retirement risk zone you are likely at the peak of your overall wealth. You need to understand where your wealth is coming from, where it goes, where it is allocated and how to withdraw it.

In the 10 years before retiring, you are likely earning the most that you will earn in your lifetime. You’ve had many years to build your career. By the time you reach full retirement age you have high income, likely with higher spending habits to match. Many seek to increase their quality of life once they stop working. This requires an understanding of your cash flow.

Many people also save the most during their last 10 working years. This often accompanies the higher salaries that people experience towards the end of their career. You should be saving what you can afford to if you don’t have substantial savings built up for your new chapter of life.

Cash Flow Planning During the Retirement Risk Zone

Cash Flow Planning

As you get older you will want to start looking towards when you can retire. People often get distracted by conversations about investing, such as their portfolio value and strategies to grow their wealth. These are useful tools that can help you. But they are only useful in terms of optimization. Before we can optimize your plan, we need to make sure that you are stabilized. Stabilization comes from understanding your cash flow.

Developing a tracking system that keeps you accountable enables you to understand your spending. There may be some shame around this process and that is a natural response. However, it is necessary to reconcile estimated spending with real numbers. A red flag in your financial professional is that they shame you, rather than encourage you.

Here is a link to our expense tracking worksheet that can help you break down your spending if you are unsure of where to start.

Expense Worksheet Template

These are examples of some common categories of spending we see with our clients.

You will want to differentiate between your necessities and your discretionary expenses. Doing so allows you to calculate your individual needs and what dials you have available to tune.

Once you have actual spending details, you can project your spending after retiring. You may plan to live modestly. Maybe you have plans for travel and excitement. These are both plans and things can always change, but they're necessary to develop so change doesn't hinder your success. A major benefit to look forward to is that you will confidently know what your cash flow looks like. Additionally, you will also be able to set real goals for yourself.

After developing a stable projection of your guaranteed income (think Social Security, Defined Benefit Pensions and Annuities) compared to your spending in retirement, you are able to estimate your required portfolio income, or RPI. Your RPI is the difference between what you'll earn from guaranteed income and what you will spend, by choice or constriction.

Here we see net and gross income needed. We then list out guaranteed income sources. The RPI is "the gap" that you have to make up if you will spend as much as we plan for.

The Gap

Whether you have a conservative lifestyle or live more comfortably than during your working years is up to you. You will need to know what is available based on what you can afford. Can you increase spending? Do you need to decrease spending? Will you have to work longer? Should you defer Social Security payments to increase benefits? This is where cash flow planning fits into the equation and you can't answer these questions without understanding your cash flow.

Retirement Income Planning During the Retirement Risk Zone

Income planning comes after accounting for cash flow and calculating your RPI. This also helps determine when you can retire.

For example, you plan to spend $6,000 per month after you retire. Your pension is guaranteed to give you $36,000 a year. You also have Social Security which will pay you $1,300 per month. 

You first want to match annual or monthly amounts to make everything digestible. So, let’s use monthly totals. Your spending is expected to be $6,000 per month. Your Social Security is also given as a monthly $1,300. Your $36,000 per year pension gives $3,000 per month. Earnings are $4,300 per month. Spending is $6,000 per month.

You can see that there is a substantial gap between what you will earn and what you want to spend. You have three options from this point:

• You can work longer.

• You can cut back your retirement lifestyle by living in a cheaper location, spend less on discretionary items, or seek out support from family and friends.

• Your last option is to take the required income gap from your portfolio.

You know that you need to earn an extra 1,700 per month. Best case you start early and plan well, so you will be able to comfortably draw money from investments.

Investor Goals

Ideally you have investable funds that can work towards your goals. The three forks of investing are growth, income and safety. Picture a triangle with each objective at separate corners of the triangle. The closer you get to one point, the further you get from the other two.

You can try to pursue high rates of return and grow your portfolio's value. This means greater risk in terms of market risk and specific risks tied to your chosen investing vehicles. More risk, more return. This is where sequence of returns risk matters when planning for distributions.

You can also choose stable cash inflow. This would open you up to two retirement risks that are very common. Inflation risk means that your investments may not generate enough return to outpace inflation. Keep this in mind when relying on an especially conservative strategy such as holding only cash. An annuity is a demonstration of this risk. Fixed annuities do not increase their benefit amount as the cost of living rises.

You can choose preservation of value so that you can leave money to your spouse or heirs. You may also temporarily shift your asset allocation for more downside protection, using preservation of capital to hopefully lower the drops in value.

A good financial plan helps retirees avoid inflation. Unfortunately, most financial advisors only do this through asset allocation. But you will need to understand that not some stocks may act like bonds, and vice versa. The same can be said for funds concentrating in stocks or bonds.

Another risk attached to cash flow goals is interest rate risk. If interest rates go down, you can't reinvest your interest payments at the same rates you originally did, which will mean lower income from investments purchased using those payments.

Your risk tolerance and personal goals will determine which path you take. Your financial situation dictates the monetary risks you can tolerate as an investor, but you also need to consider your psychological appetite for risks. Individual personality will determine what you are willing and able to tolerate in terms of risk, in the form of loss of value.

No matter how well your retirement plan is crafted you will need to have at least one backup plan that is catered to your specific needs and objectives. This may end up being a sizable amount in a savings account or a well-suited investment strategy in case the market significantly drops. Your family should make thorough plans for hard times, so that you are ready, but hopefully never need them.

No matter who you are, you're susceptible to one of the biggest risks in retirement, called "Sequence of Returns". How does sequence of returns risk affect you? The return risk can be demonstrated when you face market downturns, reducing your net worth. This happens while you're taking distributions exponentially reducing your total asset pool. This means you need increased rates of growth in the following years to hit break even.

This is one of the most ignored problems on behalf of the retiree community amongst negligent advisors. Return risk can't be ignored during your most crucial years, which are often between retiring and claiming social security. Often times, you may be struggling to produce enough money to sustain your nest egg during this period. This is a time when drawing more money than necessary can ruin your success rate. Further increasing the need for correct withdrawal strategies.

Distribution Planning for the Retirement Risk Zone

To combat risks like sequence of returns, you need a suitable distribution strategy. Many traditional methods do not take into account individual goals and needs. They also skip over some glaring risks like sequence of returns risk. This is most obvious with methods like the 4% rule that do not adapt to change.

The 4% Rule

The 4% strategy says if you withdraw only 4% of your portfolio's value every year you will never deplete the value of your investments. This works great if your portfolio is of substantial size, and most importantly, the market is guaranteed to have high rates of return every year.

What about retirees who don’t have significant wealth in investments? What about market downturn year over year? Our point can be demonstrated with the following example: We start with the same portfolio value and withdrawal rates.

As you can see here, the static 4% withdrawal rate ends up with drastic differences in ending wealth if you have the same yearly returns as a group but start out with negative years. Negative returns combined with withdrawals lead you to end up with much lower portfolio value over time. Even if using the 4% rule here implies we will never fully draw all of our assets (not guaranteed) you end up with nearly half the value.

Pro Rata Distributions

Pro rata distributions are another common strategy where you sell the same amount of each asset to make the withdrawals even. For example, you own 4 stocks and they each make up 25% of your total portfolio. When you want to withdraw 4% of your total stock value, you will sell 4% of each stock, to make this happen.

The issue here is that you aren't accounting for Indvidual positions. You can end up with taxable proceeds you were unaware of. You may sell securities that are not performing well, without giving time for rebounds. You could even sell off assets that you need in order to produce required income.

Neither of these methods are suited to your individual situation. They will inevitably leave you shorthanded and wishing that you had a tailored strategy for distributing your portfolio. The best method by far is a dynamic distribution strategy that accounts for your unique circumstances.

Here is a distribution strategy that makes more sense for a retiree that has some, but not significant spending flexibility:

Floor and Ceiling Spending

You can create guardrails on spending which follow your investment performance, with more spending in growth years or less spending during market downturns. This approach is called the "floor and ceiling" strategy.

If you have the means to, you can plan on spending less, so you take less money out of your portfolio. This helps mitigate the sequence of returns risk.

The guardrails are typically a percentage increase or decrease from your average spending. For example, you spend $4,500 per month, and the market goes down 10%, you can decrease spending by about $450 per month, so that you don't over withdraw. Should your portfolio's value increase by 10%, you can increase spending by $450 per month.

Most financial advisors will not give you a proactive plan that helps course correct before your plan is catastrophized. This is why you benefit substantially from training and education on investing and distributions, or a qualified financial advisor who has your best interests at heart.

Tax Planning During the Retirement Risk Zone

Your largest expense in retirement will be taxes. Tax planning is one area that you need to take advantage of should your plan be in an optimization state. There are a few options to reduce your taxable income.

Roth IRAs and Conversions

The first option is more viable the earlier you start. You can start to fund a Roth IRA for nontaxable distributions. Roth IRAs will enable you to withdraw your money, fully tax free, if you are over age 59 ½ and have had the account opened for at least 5 years before withdrawals.

Another option is Roth conversions. Roth conversions are when you deposit savings into a Roth plan that were originally pretax, deductible contributions. This means dollars from any traditional IRAs, 401k’s, 403b’s, and any other pretax contribution plan or annuity. Because you deducted contributions in these mentioned plans, the IRS charges tax on those contributions converted. The full conversion amount is added to your ordinary income, and taxed as such, for the year converted. The 5-year timer will start the day you initially start your Roth account.

The tradeoff here is that you will shift the tax liability from your future self to the present year. Should you be able to afford this extra expense now, you will have less tax in the future. This is another strategy that would be ideal should you have runway time before needing the funds, and the spending flexibility to fund your current lifestyle. 

Roth conversions have a breakeven point, that requires living longer than the time period which creates a financial increase in your net worth. This is typically several years beyond the actual conversion.

You also want to consider what type of accounts you own. The benefit of taxable accounts is simplicity; there are no rules to remember. However, you lose the benefits of tax-deductible contributions and tax deferral on withdrawals. 

IRMAA and Medicare

Another factor to consider is something called IRMAA surcharges on your Medicare premiums. IRMAA stands for Income Related Monthly Adjustment Amounts, affecting the amount you pay per month for Medicare Part B and D premiums. When your income is above a certain threshold you will have to pay a set amount of IRMAA surcharge in addition to your premiums. Both also get increased every year for inflation.

The catch is that IRMAA surcharges for a given year are based on your income from two years prior. The only way to avoid this is to reduce your taxable income. Ideally, this will be reorganizing your assets into tax free withdrawals before you need Medicare. 

Bringing it All to a Close

The retirement risk zone can be harsh and daunting. Fortunately there are steps you can take to protect yourself, and even thrive in successful retirement. The earlier you start the earlier you are in control of your plans. You can only be too late if you never get started. While the work may feel difficult at the moment, it will pay off multiple times over when you can reach retirement age and enjoy the fruits of your labor. Organizing the steps you need to take will enable a digestible action plan to be created. 

Click here to see a comprehensive sample financial plan.

First you must understand where you are in proximity to your goals by gathering an accurate picture of your current situation. This requires accounting for what your finances look like right now. You will want to obtain your financial documents, and sort through all of your assets and obligations. Once you have a clear grasp on where your net worth we can move on.

The second part of the plan is understanding your specific retirement risks by detailing your current and expected cash flows. You will want to know how much you are earning from any current sources of income. Next you think about how much you expect to spend after retiring. The amount of cash flow coming in and going out will help determine how close you are to your goal of retiring.

Next, you have to account for any missing gaps in income. That can come from a myriad of sources, but if you plan to spend more than you make, it has to be accounted for. If you have the means to provide for yourself, hopefully you will have retirement savings to fill income gaps with liquid assets.

This creates a series of nested decisions based on the forks in the road. We must account for tax and distribution strategies. Hopefully you or your financial professional will be knowledgeable in navigating the mechanics of investing and distributions. An uneducated or confused investor can drain their retirement savings without accounting for taxes and investment performance.

FAQ:
1. How do I start planning for my retirement?

Starting to plan for retirement means breaking down your current situation, your cash flow plans, and retirement income plans. Each step has a checklist that you can follow. The very first step is understanding where you are in terms of financial security at this current point in time. 

2. When can I retire?

The decision of when you can retire depends on your cash flows, and your assets available to support any needs you may have. Cash flow planning is a prerequisite for getting to this stage. 

The simplest form of the equation is:

Guaranteed income + investment income - expenses in retirement = required dollars

3. Can I afford to retire?

Whether or not you can afford to retire depends on the above equation. You must calculate the estimated amounts of income from guaranteed sources (Social Security, Pensions, etc) and what your portfolio will be able to support and then adjust the retirement spending accordingly.

4. How can I avoid taxes in retirement?

The best ways to reduce taxable income are tax free sources like ROTH IRA’s, having long term capital gains, or more complicated strategies such as tax loss harvesting.

5. How do I take distributions in retirement?

Taking distributions in retirement will be a crucial part of your success. The best way to take distributions is by using a dynamic strategy that adapts to your individual situation. No blanket rule will serve you well for your entire retirement. 

Other Financial Planning Resources:

• How do Financial Advisors get paid?

• What is a Fee Only Fiduciary Financial Advisor?

• What is a Comprehensive Financial Plan?

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If you found the information above helpful, click here to watch my free Masterclass training that explains how you can increase your income in retirement by up to 30% and avoid running out of money in retirement.

What is Capital Preservation?

What is capital preservation?

It is a defensive investment approach aimed at preventing or minimizing the loss of your original capital.

This strategy is especially relevant for risk-averse investors or those reaching retirement, for whom a financial setback can be hard to recuperate.

In this guide we will explore capital preservation and provide you insights into maintaining the value of your investments, particularly in times of economic uncertainty.

We will also address how to consider factors like inflation that eat away at your investments purchasing power.

Key Takeaways

• Capital preservation is an investment strategy that prioritizes maintaining the initial value of the investment over seeking high returns, typically employing low-risk assets like government bonds, FDIC-insured accounts, and money market funds, and is particularly suited for retirees or those with low risk tolerance.

• Crafting a capital preservation portfolio requires careful selection of low-risk assets, diversification across asset classes, and adopting risk management strategies, while taking into account the potential impact of inflation and interest rates on investments such as bonds.

• Working with a financial advisor is beneficial for aligning capital preservation strategies with one’s financial goals, risk tolerance, and time horizon.

Table of Contents

1. What is Capital Preservation?

2. Crafting a Capital Preservation Portfolio

3. Understanding Risk Tolerance and Time Horizon

4. Navigating Inflation and Interest Rates

5. Consulting a Financial Advisor

What is Capital Preservation

Capital preservation refers to an investment approach that focuses on preserving the initial capital (investment amount) and minimizing any potential losses.

It prioritizes security over high returns, making it a preferred strategy for many investors. One of its main challenges is inflation, which can decrease the actual value of investments.

Investors who prioritize capital preservation typically opt for conservative options such as bonds, cash, and money market funds in order to maintain stability. Government-insured products like FDIC-insured offerings or Treasury bills may also be viable choices.

This investment strategy is particularly suitable for individuals at retirement age who are risk-averse and seek to protect their principal amount while using their investments for covering living expenses.

Click here to schedule a free consultation with our fee only fiduciary financial planning team.

Capital Preservation Strategy in Practice

The core principles of capital preservation include adopting a conservative investment strategy focused on protecting and reducing potential losses within a portfolio.

It involves evaluating risks and volatility levels in order to stabilize the dollar value of the investment.

This should be done at two levels - the global level and the detail level.

At the global level, we manage risk by:

1. Diversifying the investment holdings

2. Identifying the appropriate target rate of return

3. Building a foundation of education

At the detail level we manage risk by:

1. Understanding the risks of the individual investments we hold

2. Avoiding concentrating too much capital into a single investment or position

3. Having a system to regularly monitor the performance of the portfolio

4. Having contingency plans in place if our assumptions don't go as expected

While these are sound portfolio management techniques that should be applied in all circumstances, the method of application will differ depending on your investment strategy and goals.

Capital Preservation vs. Capital Appreciation

There are 3 predominant investing strategies:

Capital Appreciation

The objective of a capital appreciation strategy is to buy an investment at a low price and sell it at a future date for a higher price.

In this strategy you must SELL the investment in order to regain access to your underlying investment dollars.

The focus is on buying higher risk assets with greater opportunity for growth in order to capitalize on the increase in price over time.

Portfolio Income

The objective of a portfolio income strategy is to produce "passive" income generated with minimal risk WITHOUT SELLING the underlying investments.

Usually, you will have to give up some opportunity for growth in the form of price appreciation in order to generate the portfolio income.

Capital Preservation

The objective of capital preservation is to protect your original investment money while at least matching the rate of inflation so that you do not lose purchasing power over time.

Investors should consider transitioning to a capital preservation plan when approaching retirement age or shifting their focus from growing their portfolio to safeguarding its value against potential losses.

Examples of common tools used for achieving effective capital preservations include FDIC insured checking accounts, savings accounts, Treasury bills, certificates of deposit, and high-quality bonds. These financial instruments are specifically designed to reduce the risks associated with investments.

Click here to schedule a free consultation with our fee only fiduciary financial planning team.

When Capital Preservation Works Best

Capital preservation is a favored approach for investors who are nearing retirement or have a low risk tolerance.

Its main goal is to safeguard the initial investment and minimize the chances of losing the principal.

Retirees, in particular, need to prioritize capital preservation due to their short time horizons which limit their ability to recover from market losses.

Capital preservation investment strategies are particularly useful to protect against sequence of returns risk.

You can read our guide "Navigating the Retirement Risk Zone" and Sequence of Returns Risk here.

Managed properly, a retirement portfolio constructed with a capital preservation strategy should be able to outpace inflation and maintain the purchasing power of your capital over time.

Crafting a Capital Preservation Portfolio

Building a successful capital preservation portfolio requires deliberate consideration of low-risk assets, diversification, and risk management techniques.

The ultimate goal is to minimize the impact of market fluctuations and provide a safety net for your capital.

We use the following checklist when constructing a capital preservation portfolio:

1) Ignore Asset Allocation (you can read our longer opinion and guide to asset allocation here)

2) Identify your "Required Portfolio Income"

3) Identify your financial plan required rate of return

4) Construct a portfolio "1st draft" where no single position is larger than 5% of the portfolio value

5) If using Exchange Traded Funds, verify that there is not significant overlap in investment holdings between the funds you select

6) Use a tool such as portfolio visualizer to back test your model over at least a 10 year period.

7) Understand investment terms such as "Beta", "Market Correlation", "Worst Year", "Max Drawdown", and Rate of Return, and compare your model portfolio against other alternatives.

8) Once satisfied with your model portfolio's measures of beta, market correlation, worst year, and rate of return, execute your portfolio

9) Monitor your performance in both offensive and defensive statistics quarterly.

Click here to schedule a free consultation with our fee only fiduciary financial planning team.

Asset Classes for Capital Preservation

It's important to understand that asset classes alone are not a sufficient guide about the level of risk or stability of an investment.

If you haven't already read or watched our guide to asset allocations, we encourage you to do so here.

Bonds are typically thought to be conservative (preserving capital), and stocks thought to be risky.

However, some bonds function more like stocks, while some stocks function more like bonds.

Bonds that function like stocks would be Exchange traded funds that are long term bond funds such as TLT (10+ year US Bonds) or EDV (20+ year US Bonds).

Bonds as an asset class are "conservative", however a fund such as TLT or EDV can have HUGE price swings as interest rates change.

Conversely, stocks that function more like bonds would include defensive (value) stocks such as VZ, T, PG, or KO.

These stocks will not have "wild" swings in price and instead pay their shareholders a dividend as an incentive to hold the position since the holder will likely not see significant price appreciation over time.

With this in mind, throw asset classes out the door and instead focus on the more minute categories of investments that ACTUALLY preserve capital when constructing your capital preservation portfolio.

The types of investments we favor in capital preservation portfolio's include:

1) Value Stocks

2) Consumer Staple stocks

3) Health Care stocks

4) Money Market accounts

5) Short term US Government bonds (less than 5 years in duration)

6) Certificates of Deposit

7) High Yield Savings Accounts

The Role of Fixed Income Investments

Fixed income investments are types of assets or securities that provide a predetermined amount of interest income, also known as "Bonds".

A bond is essentially a loan you give to either a government or a company.

The entity promises to pay you back the ENTIRE original investment after a predetermined amount of time, and along the way will pay a stated interest rate in return for your patience.

The main purpose of fixed-income investments is to generate steady income for investors through regular payments until their maturity date when the initial investment is returned.

These types of investments come with various risks including credit risk, spread risk, downgrade risk, liquidity risk, inflationary risk and interest rate fluctuations which can impact the value and stability of one’s capital.

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Understanding Risk Tolerance and Time Horizon

Risk tolerance refers to an investor’s ability to handle the potential risks associated with investing and the potential fluctuations in investment value.

Experts suggest that as individuals age, they should gradually decrease their risk tolerance. This means being more conservative when investing money needed within a shorter time frame.

Protecting principal becomes increasingly important for those nearing retirement who may face market volatility which can threaten their financial stability if they will be relying on their investment assets for income.

Aligning Investments with Time Horizon

Investing for shorter periods of time may require a cautious approach to safeguard capital, while longer investment horizons allow room for more aggressive strategies that could yield higher returns.

A common capital preservation strategy that illustrates this is the Retirement Bucket Strategy, also known as the 3 Bucket Strategy.

The timeframe in which investments are made affects the use of capital preservation techniques by prioritizing protection of the initial amount invested instead of chasing after high profits, resulting in a more conservative asset allocation.

Capital preservation methods can also benefit long-term investors through minimizing losses during market downturns.

The strategy chosen varies based on the desired time horizon as short-term investing calls for a greater portion being allocated towards safer, more liquid, more stable investments.

On the other hand, medium- or long-term investing requires having a balanced spread among a wider range of investments more capital appreciation potential.

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Navigating Inflation and Interest Rates

Investments focused on protecting capital can be affected by the gradual devaluation caused by inflation.

An improperly executed capital preservation strategy may not outpace the reduction in purchasing power caused by inflation.

As such, we advise most individual investors to seek out the help of a fee only fiduciary financial planner who can help educate and construct this type of portfolio strategy.

Capital Preservation Inflation Risks

Inflation is the erosion of purchasing power over time because of the increasing cost to produce and sell goods.

The reason we invest for retirement AT ALL is to maintain our saved dollars purchasing power.

When interest rates are exceedingly low, as they have been from 2009-2022, interest bearing investments (fixed income investments) may not outpace inflation and result in negative real rates of return, dissuading investors from using a capital preservation strategy.

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Interest Rate Influence on Bond Prices

The relationship between bonds and interest rates is inverse. As interest rates go up, bond prices decline, while decreasing interest rates lead to higher bond prices. This is because rising interest rates make the fixed rate on existing bonds less desirable compared to new ones issued at a higher rate. As a result, there is reduced demand for current bonds leading to their price decrease.

On the other hand, lower interest rates typically cause an increase in bond prices due to the more attractive nature of preexisting high-interest-rate bonds resulting in greater demand and subsequent increases in value.

Consulting a Financial Advisor

Seek guidance from a fee only fiduciary financial advisor who leads with financial planning when considering how to best position your capital preservation investments:

• Determining the best mix of investments to match your objectives, level of risk tolerance, and timeline

• Ensuring that your investment approach is aligned with your personal risk profile

• Diversifying your portfolio effectively

• Adapting the investment strategy as needed over time

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The Value of Expert Advice

Just as reading a book can shortcut your timeline to expertise on a subject, so too can hiring a professional.

Remember - when you try to learn how to invest your retirement savings on your own, you are taking a gamble with your own money.

You are essentially saying that you will pay less in the form of making mistakes on your own then you would pay a financial planner or financial advisor to shortcut your mistakes.

When it comes to preserving capital or even investing in growth strategies, it's critical to first begin by constructing a detailed financial plan, a road map that tells you how much to save, what rate of return you need, how to minimize taxes, and ultimately how to construct your investment portfolio.

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Summary

In summary, maintaining capital is a crucial tactic for all investors, especially those who are approaching retirement or have a conservative attitude towards risk. This strategy involves carefully choosing low-risk investments, creating a diverse portfolio, understanding personal risk tolerance levels and managing the effects of inflation and interest rates. Although it may seem daunting at first glance, always remember that seeking expert advice can guide you through these challenges. Safeguarding your wealth requires patience, wisdom and strategic planning over time rather than quick fixes - with the right approach, you can protect your assets and achieve desired financial objectives.

Frequently Asked Questions

What is an example of capital preservation?

One way to preserve capital is by investing in secure options provided by the government such as FDIC-insured checking and savings accounts, certificates of deposit, and U.S. Treasury bills. These types of investments are considered low-risk and aim to safeguard your initial capital.

Why is capital preservation important?

Capital preservation is important because it shields investors from market volatility and is commonly used by individuals with a fixed income or retirees to secure their living expenses in the future. The focus is on protecting the investment rather than generating significant profits.

What is capital preservation how the market works?

Capital preservation is the concept of protecting the money you’ve invested, to ensure that you don’t end up in a scenario where not investing would have been the better choice. This is a fundamental principle in investing.

Are capital preservation funds safe?

Investments in capital preservation funds aim to safeguard the value of your investment, but there is no assurance or guarantee. These funds are not backed by government agencies and carry a certain level of risk for investors looking to protect their capital.

What is the primary objective of capital preservation?

The main goal of capital preservation is to prioritize the security and protection of the initial investment amount. It emphasizes safeguarding the invested capital rather than striving for significant profits.

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