When I think of a bucket list I think about things I want to see and do before I die.
Recently I read about another type of bucket list on Seeking Alpha. In his article called: “The Changing Logic Of Asset Allocation In Retirement,” Michael Lonier discusses a very interesting way to think about your retirement assets.
He explores a way to compose a retirement portfolio (or more accurately four retirement portfolios) to address four sets of needs in retirement:
- floor (or what you must have to live on year-to-year)
- longevity (how long you need your funds to tide you over for)
- reserves (for coping with emergencies and the unplanned)
- upside (where you take some risk so you can enjoy some of the finer things in life without imperilling the three other needs)
Please note that I am not endorsing this approach (at least not yet); rather I am presenting it for the perspective it brings to the discussion of how to manage a retirement portfolio.
My take on this approach
I like the idea of bucketing our retirement portfolio so that our basic needs (floor), discretionary spending (upside), longevity risk and reserves are accounted for.
To calculate our basic needs bucket I first look at our expected cash flow from Canada Pension and Old Age Security. I then compare that to our current budget for essentials (housing, food, clothing, and so on). The difference needs to be made up by one bucket of our portfolio. I will then assume a 3.5% rate of return (adjusted for inflation) for this bucket (presumably made up of real return bonds or a short-term bond ladder of standard corporate or government bonds).
I then look at our discretionary wants by taking our current budget, subtract the amount needed for essentials and subtract anything we won’t spend on in retirement (e.g., work-related expenses, disability insurance, life insurance, etc.). That gives me the amount needed to be funded by the discretionary (upside) bucket. I will then assume a 6.0% total rate of return (adjusted for inflation) for this bucket (presumably made up of mix of dividend paying and dividend growing companies).
I then look at our longevity probabilities based on actuarial tables and add seven years to the expected lifespans for the two of us for good measure. That defines the third bucket. I will then assume a 7.5% total rate of return (adjusted for inflation) for this bucket (presumably made up of growth stocks – I am not yet sold on annuities, but may be convinced otherwise in future).
Finally, I look at how much I want us to have in reserves and figure around two years of income should do it. That defines the fourth bucket. I will assume no return (just inflation) for this bucket (presumably made up of short-term bonds, GICs and/or money market funds).
Here’s what our buckets look like in percentage terms of our portfolio:
- Basic needs – beyond Canada Pension and Old Age Security (floor): 30.5%
- Discretionary (upside): 40.2%
- Longevity: 19.7%
- Reserves: 9.7%
One surprising takeaway from this analysis is that we’d actually need to increase our stock holdings from our current 50% to 60% (assuming no purchase of an annuity). I’ll have to give that some more thought as I think sequence of return risks will temper that a bit in the early years of retirement. Longevity risk may have to be funded more conservatively for the first few years of retirement if I don’t buy an annuity.
I find it’s an interesting way to look at a retirement portfolio. My calculations are pretty “back of napkin” right now, and I make broad assumptions about tax rates and total rates of return by asset class. Nevertheless, it is a useful exercise to think through how much or how little risk is needed to fund a retirement.
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