Early retirement is different.
Every retirement plan is based on a combination of goals, risks and personal budget. You want to build a portfolio for security, so you never need to worry about money again, while also generating the returns that you need to maintain your lifestyle. Often, this means restructuring your portfolio in retirement away from growth and toward safer, long-term assets. This works well for most people, who will retire in their mid- to late-sixties and need a portfolio to last for an average 25 to 30 years.
But when you retire early, things change. You need to anticipate more spending, more obligations, more inflation, and less time for compounding returns, among other potential issues. You need a different plan, and you certainly need more in savings.
For example, say that you’re 54 and getting ready to retire. You have $1.6 million in your retirement portfolio. How should you structure this portfolio? Here are a few things to think about.
When it comes to structuring your portfolio, one of the first issues to consider is how to balance capital gains vs. income. This is also typically phrased as “returns” vs. “yields.”
Broadly speaking, capital gains are generated when you sell assets and withdraw the profits. The most common example of this is when you sell stocks, bonds, fund shares or similar assets and keep the money.
Income, on the other hand, is when your portfolio generates cash flow without affecting the underlying assets. The most common example of this is when a bond or depository account returns interest, or when a stock pays dividends.
In most cases, capital gains and income have different profiles. When you emphasize capital gains, your main advantage is the opportunity for growth. In most cases, you will make more money by selling assets for profit than you would by holding them for potential future income. What’s more, many assets don’t even generate income. Most stocks, for example, do not pay dividends. You must sell them to make money.
A portfolio that emphasizes capital gains has two main disadvantages. First, it tends to be higher volatility and higher risk compared to income investing. Second, selling assets draws down on your portfolio’s principal. While you can reinvest some of your money, this still reduces your portfolio’s overall value.
An income portfolio typically mitigates those issues. Income-generating assets like bonds, dividend stocks and annuities tend to have less volatility and lower risk than return-oriented assets. You also do not need to sell your underlying assets to collect income, so you don’t have to erode the portfolio’s value to draw value.
On the other hand, income assets are generally characterized by much lower rates of growth. You tend to see much less money from an income-oriented strategy.
An easy example of this is to look at the average annual returns of the S&P 500 vs. the average annual yield of a corporate bond. The stock market as a whole generally returns about 11% per year, meaning that if you invested $100 in the market and sold it 365 days later you would typically have $111.
A triple-a corporate bond, on average, pays about a 5% interest rate, meaning that same $100 would grow to $105 over a single year.
But the S&P 500 also fluctuates widely. In a single year your money might grow to $130 or it might drop to $85, depending entirely on if the market booms or busts. And to withdraw your money, you would have to sell your assets, pulling that capital out of the market. On the other hand, your bond will steadily return that same $5 year over year, and you can leave the underlying $100 in place the whole time.
Consider speaking with a financial advisor for a second opinion on your investment strategy.
When it comes to early retirement, among others, you should consider two competing issues.
First, a long retirement will be expensive. Starting at age 54 or 55 means that, you could be retired for around 35 years, or more. With this in mind, you should plan for some growth-oriented investing to make sure your portfolio has enough money to meet your needs. Capital gains can help provide this kind of growth.
On the other hand, a long retirement involves careful tending of your assets. The less you draw down on your portfolio’s principal, the longer your assets can last. Income assets can provide that kind of longevity, giving you lower-volatility assets that keep generating money without drawing down on your principal. In theory, a best-case retirement portfolio could fund an indefinite retirement by generating enough income to live off comfortably without ever needing to touch the assets themselves.
Structuring the right portfolio will, typically, require a balance of these two approaches.
If you retire at age 54, it will be years before you can collect Social Security. You might not begin to draw benefits until age 67. While you could begin collecting at age 62, this would significantly reduce your benefits. Since even these reduced benefits are still eight years away, your best approach is to build a comfortable retirement based on your portfolio assets and plan on using Social Security to supplement your savings or hedge against inflation.
What kind of income you generate will depend entirely on your approach to investing. To see this, let’s look at four different portfolio types. Note that you would almost certainly not use single-strategy portfolios, like the ones we will discuss here. These are just representative examples.
First, you might invest everything in corporate bonds. Triple-A rated corporate bonds have generated an average interest rate of around 5% in recent years. This portfolio might generate around $80,000 per year of indefinite, highly secure income based on the interest payments of the underlying bonds. But this income also will not grow, exposing you to potential pressure from inflation and taxes.
You might, instead, build a mixed portfolio of bonds and stocks. A portfolio like this will, in general, return around 8% per year. This figure can vary widely, but 8% is a common rate of return for a portfolio that balances the 5% average interest rate of bonds with the 11% average return of the S&P 500.
This portfolio might generate around $128,000 of annual income, based on a combination of selling equities and collecting bond interest. However it would have more risk and volatility due to the inclusion of equities.
An aggressive strategy would be to leave your entire portfolio invested in the market. This typically would mean investing in an S&P 500 index fund for its average 11% interest rate.
The advantage to this approach would be growth. You could, potentially, generate around $176,000 per year just in returns, before you even account for drawing down on principal. The downside would be significant volatility, with your money exposed to the ups and downs of the stock market.
Or you could invest in a lifetime annuity. These products, sometimes referred to as private pension plans, offer guaranteed income for life in exchange for an initial investment. Your exact outcome will depend entirely on the product you buy, but a representative annuity might generate about $100,368 per year of income for life. This gives you a lot of security, but it also costs you opportunities for growth and leaves you very exposed to inflation.
Remember, these examples are simplified for illustrative purposes. A financial advisor can help you make calculations and projections based on your own goals and assumptions.
Once you have a sense of how you will structure your portfolio and what kind of income it will generate, your next step is to plan for long-term costs. Most importantly, you should plan for taxes and inflation.
Taxes depend entirely on the type of retirement portfolio(s) you have. This falls into three main categories:
A Roth portfolio is tax-free. This means that you will not pay income taxes, nor will you have to plan for Required Minimum Distributions (RMDs). You can plan to live on the full amount you withdraw from this portfolio, absent individual circumstances.
A pre-tax portfolio, like a 401(k) or a traditional IRA, is taxed as ordinary income when you make withdrawals. This applies to principal and gains. You do not pay FICA/payroll taxes on these withdrawals, but you will pay state income taxes. You must also plan to begin taking RMD withdrawals starting at age 73. (This age will likely increase by 2042.)
Finally, a taxed portfolio generates taxes based on the nature of the assets within it. In some cases this means capital gains taxes for any assets that you sell, and income taxes for some types of interest and yields. Like a pre-tax portfolio, you will not owe payroll taxes on the money you withdraw from a taxed portfolio. You will also not have Required Minimum Distributions on this portfolio. A financial advisor can help you navigate and strategize around taxes.
Finally, any retirement needs to anticipate inflation. This is particularly true when you retire early, since the additional years of retirement mean that much more time for prices to grow.
Don’t underestimate this. For example, even at the Federal Reserve’s target 2% rate of inflation a product that costs $100 when you are 54 will cost $122 by the time you’re 64. In 20 years, that product will be $150.
At this rate, you can expect prices to double about every 35 years.
Generally, the best way to manage this is by investing for growth and returns. In particular, equities tend to grow in line with inflation, allowing stock market assets keep up with costs. While stable income is good for security, low- or no-growth assets like bonds or annuities will not keep up with inflation. Year after year, your portfolio will lose purchasing power with assets that don’t keep up with rising prices. Make sure to anticipate this as you structure your investments, and talk to a financial advisor if you are interested in professional guidance for putting the parts of your retirement plan.
If you’re retiring early, it’s essential to structure your portfolio well. In particular, start by considering how you will balance your need for long-term growth against your need for long-term security.
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Seriously, don’t underestimate the importance of good tax planning when you prepare for an early retirement. Start with these tax strategies.
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A financial advisor can help you build a comprehensive retirement plan. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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Keep an emergency fund on hand in case you run into unexpected expenses. An emergency fund should be liquid — in an account that isn’t at risk of significant fluctuation like the stock market. The tradeoff is that the value of liquid cash can be eroded by inflation. But a high-interest account allows you to earn compound interest. Compare savings accounts from these banks.
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