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How can I balance my portfolio’s need to generate cash flow with my desire for principal growth?

“There is no set rule on how your portfolio should be allocated in retirement.”

Lifestyle, California, USA

How can I balance my portfolio’s need to generate cash flow with my desire for principal growth to leave a legacy for my children?

These are two very common and primary concerns in retirement. Tackling the dilemma of providing cash flow to meet expenses is a process, and you need to start in the months prior to your retirement date so you can build your portfolio’s structure to meet your income goals. The first thing you need is a budget/spending expectation in your retirement years.

A common mistake people make in retirement is that they get too conservative or stay too aggressive in their portfolio construction. There is no set rule on how your portfolio should be allocated in retirement. Each person’s situation is unique, so instead, we’d prefer to build your strategy to be customized according to your cash flow needs.

To do this in retirement, we need to plan on creating different “buckets” of money in the portfolio. Fixed income can represent anywhere from 25 to 40 percent of your portfolio allocation.

This portion of the allocation provides part of the steady stream of retirement income and helps offset stock market volatility. You will have a short-term bucket, a portion of the money that you will spend over the next five years, which is constructed using individual investment-grade bonds maturing each year for the next five years. The remaining allocation to fixed income could include junk bonds, mortgages, TIPS and international bonds.

Alternative assets would represent about 10 to 20 percent of the portfolio. This could include private real estate, private debt, covered call strategies and other nontraditional strategies that would not correlate as much to the equity and fixed-income markets. As such, this category is designed to both help augment income and provide smoother portfolio returns over time.

Now, to help make sure the principal can sustain these annual expenses but also leave some desired legacy to your children, you need to have enough money in equities to provide for long-term appreciation. Your equity portion of the portfolio is your 10-plus year money. These are the assets that will help keep pace with inflation and leave the legacy to your children. The equity portion of the portfolio could represent 40 to 60 percent of the portfolio, depending on the client’s needs and objectives.

As we construct the total portfolio with all the aforementioned asset classes, we target a 3 percent yield from interest and dividends from all assets combined. This 3 percent yield becomes a portion of the spendable income for the client in retirement in combination with the individual bonds maturing. Matching this combination to the target retirement income need provides a few positives for the client. Cash flow is not affected by the fluctuations in the stock market. When the stock market has a downturn, you don’t have to rely on the equity markets for returns so you can live comfortably in retirement. This gives you time to let the market recover so you don’t need to sell assets at depressed levels. During years when equity markets provide appreciation, you will rebalance the portfolio by selling equities as they appreciate and continue to backfill your bond ladder or other fixed-income assets, which will replace the bonds that matured or were spent.

This strategy will allow you to live on your portfolio’s cash flow and provide your equity/risk assets to appreciate over time to leave a legacy to your children.

Retirement PlanningWealth Management

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