- Creating a Cash Reserve
- Variable Annuity
- Longevity Insurance
- Using Payout (Mutual) Funds
Of the approaches outlined above, "Creating a Cash Reserve" seemed to be the most level-headed approach, followed by the use of Payout Funds such as Fidelity's Income Replacement Funds (mentioned in the article), along with Vanguard's version just released, known as Managed Payout Funds.
Although I am not opposed to them philosophically, I am generally wary of insurance-based products - they clearly need a lot more homework on part of the investor prior to purchase and their generally higher fees tend to eat into the principal and future returns.
Creating a Cash Reserve:
Harold Evensky and Deena Katz, who run their own advisory firm in Coral Gables, Fla., are authors of several books about investing and are among the most prominent figures in the financial-planning industry. The couple (they're married) have used their "cash-flow-reserve strategy" to create regular paychecks for retirees since the 1980s, and they've successfully weathered difficult markets in 1987 and 2000-2002.
The approach was born out of the pair's dissatisfaction with two commonly used strategies for generating cash from a nest egg. Strategy No. 1, relying solely on income from dividends and/or interest, simply "makes no sense," Mr. Evensky says. Such a nest egg requires a hefty percentage (typically 50% or more) of bonds or bond funds to generate needed cash, and, thus, limits one's stock holdings. Stocks, of course, have historically provided the growth needed in a portfolio to guard against the loss of purchasing power.
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Initially, Mr. Evensky and Ms. Katz came up with a "five-year" plan for their clients. Let's say a retiree has $1 million in savings and needs $40,000 a year to supplement other income (like Social Security). With that in mind, $200,000 (five years x $40,000) would be set aside in say, a money-market account. The remaining $800,000 would be invested in a well-diversified portfolio. The money-market account would be used to pay monthly bills, and the account would be "refilled" (periodically) from gains in the investment portfolio.
The thinking: The "real risk" with a nest egg, according to Mr. Evensky, is having to sell holdings when markets are falling in order to meet spending needs. (Remember: reverse-dollar-cost averaging.) Carving out five years of living expenses would all but eliminate that risk; if markets were falling, the five-year cushion would provide funds to buy groceries, etc., and the client could wait until markets rebounded before refilling the money-market account. The problem: Setting aside a full five years of cash in a vehicle with relatively low returns (like a money-market account) put a significant damper on the nest egg as a whole.
So, the couple tinkered with their formula, and today provide clients with three accounts. The first is a simple checking account. The second is a "cash-flow reserve portfolio" with approximately two years of spending money. Half of that money (or one year of spending) is placed in money-market funds; the other half is invested in a low-cost bond fund, with high-quality short-term (meaning one-year duration) municipal bonds. Once a month, the client transfers a "paycheck" from the reserve account to his or her checking account.
The rest of the nest egg goes into the third account: a long-term investment portfolio. Here, about 70% of the money is invested in stocks and 30% in bonds -- typically divided among those with one- to three-year maturities, three to five years, and five to 10 years. When it's possible to sell stocks without significant losses, a client moves money from the investment portfolio into the cash-flow reserve to bring the balance back up to two years of spending power.
What happens if there's more than a year with significant losses in stocks? At that point, Mr. Evensky explains, the client turns to the bonds in the investment portfolio, which function as "second-tier emergency reserves." No matter how bad the markets get, bond investments are unlikely to have significant losses; thus, you could refill the cash-flow reserve by liquidating some bonds, and buy time to defer the sale of stocks in a bear market.
Using Payout Funds:
A third option is a "payout" fund, offered by large mutual-fund companies such as Fidelity Investments, Vanguard Group and Charles Schwab. These products, which automatically generate a monthly payout, are actively managed with a goal of reduced volatility, and are designed to provide you with a steady paycheck for a set time period (though some try to return at least some of your initial investment and others don't). The fees, ranging from about 0.5% to 1.9% of the portfolio's value each year, are generally cheaper than those charged for annuities. But there's no guarantee that the investments won't lose value, or that the corresponding monthly checks will stay the same size. One other hassle: If you hold such a fund in a taxable account, you have a capital gain or loss to report each month shares are sold.
For example, if you invested $100,000 in Fidelity Investments' Income Replacement 2028 Fund, the monthly payment for the first year would be $543. If the fund's returns are higher than 10%, the second year's monthly payments would rise to $580. But if the fund loses more than 10% in its first year, the monthly payments for the second year would drop to $471. Those monthly payments may or may not keep pace with inflation, and will result in the gradual liquidation of the investment by its end date.
Emphasis Added
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