These questions are more important than many retirees realize. Decisions about your principal, whether to exploit it or keep it for your heirs, can make a big difference in how retirees invest their money and, as such, how much risk they have to take next.

I asked Charlie Farrell, a CEO in Denver with Beacon Pointe Advisors, if he could handle some numbers and discuss what makes a portfolio durable in the future life. Here are some excerpts from our conversation:

WSJ: Are retirees looking for or embracing a particular type of portfolio today?

MR. FARRELL: I think retirement is mainly about a more comfortable lifestyle in its various forms. As the risks of things like health challenges rise and as we face the reality of reaching the end of our life, most people would prefer more comfort or stability around their finances if possible. In general, this means portfolios with lower volatility.

WSJ: How do you build a “comfortable” wallet? And how do you relate to touching, or not touching, your retired principal?

MR. FARRELL: The level of comfort you can get in a wallet depends more or less on two things: whether you agree to spend less capital and whether you have control over what I will call your personal inflation rate. If you are okay with spending the capital, in other words, you don’t have a specific goal of leaving a legacy to children or charity, and you simply leave whatever is left and if you have control over your personal inflation rate, have a lot more. flexibility to design a less volatile portfolio.

WSJ: How do you determine your “personal inflation rate”? And how do you control it?

MR. FARRELL: You could add up everything you spent in one year and then add up everything you spent the following year and compare the numbers. But a more practical approach is to manage your money at a personal inflation rate of your choice. In other words, spend within a specific budget and limit your personal rate to a certain percentage.

Let’s say inflation is 8% and you want to limit the inflation rate to 5%. In that case, you would not be spending more than 5% more than what you have spent monthly in the future. This way you will be forced to manage your money up to that number and make the cost and quality tradeoffs required to reach that number.

WSJ: What are some of the trade-offs?

MR. FARRELL: Let’s say you spend $ 120,000 a year, but only $ 50,000 of that is on essentials like utilities, health care, taxes, insurance, maintenance of your home. The rest is discretionary: entertainment, travel, hobbies, etc. You can’t do much for your auto insurance, for example. But you can make different choices around discretionary spending.

The point is to experiment with what you are doing and see if you can keep inflation in check in retirement and continue to enjoy life. For example, you may want to buy an expensive car, but decide to buy a more modest model. If you can do this, if you can keep your personal inflation rate in check and possibly even lower it, that reduces the pressure to increase the annual withdrawals from your nest egg. And that means you need fewer returns to make your savings last that long.

Historically, the toughest cycles for retirees have been those with high inflation and falling or stagnating markets – basically what we have today. If it only lasts a year or so, that’s not a big deal. But if it drags on, it will be a bigger challenge.

WSJ: Let’s talk about returns. What kind of return would a couple need if they were willing to exploit their principal against a couple who would like to preserve him?

MR. FARRELL: Let’s say you start with $ 1 million and withdraw 4%, or $ 40,000, per year and have no inflation or portfolio growth. The money will last 25 years. So to get to 30, you only need about 1.5% return on your portfolio, if inflation is 0%. If you move inflation to 2%, you will see that a total return of around 3.5% is required to reach 30 years (a return of 1.5% plus the inflation rate of 2%). Move inflation to 3% and you can earn 30 years if your return is 4.5% and so on.

So about a 1.5% yield above inflation will make the money last 30 years. This is on paper, of course, but it gives you a basic idea of ​​how much extra return you need. It’s not too much, actually, if you’re okay with spending the capital over time.

WSJ: And what about the couple who want to keep the principal?

MR. FARRELL: Here, you’d need about 3% to 3.5% above inflation, with inflation between 2% and 4%. Let’s say your personal inflation rate is 2%. In that case, you’d need a yield of around 5% to 5.5%. While it doesn’t seem like much more, you probably should be allocating significantly more to stocks to try and get this return.

If you assume a 3% bond yield and a 6% equity yield, you would need just over 80% of your money in stocks to achieve a portfolio return of 5.5%. But to get a 3.5% return, you would only need about 30% in stocks. Therefore, the desire to keep capital makes a big difference in how much risk you might take.

WSJ: It sounds simple.

MR. FARRELL: Well, these are spreadsheet guesses, and of course, the real world is a lot messier. Who knows what returns will go on. But if you need more returns, you will need to hold more in stocks, which increases volatility and uncertainty and thus generally increases the discomfort.

So, if you don’t mind the possibility of consuming capital over time and if you can control your personal inflation rate, you can be more cautious and, therefore, have more comfort. It really comes down to what things are most important to you.

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