Your Nest Egg
By Kevin & Roger Katzenmaier
November 7, 1998
Here we go again with
one of the most overused retirement planning metaphors---the
nest egg---that bundle of money set aside for the future.
But this particular metaphor implies something important that is often missed.
planning includes more than just sitting on and growing invested
capital. The ultimate purpose of the nest egg is to be hatched!
It is not surprising
that most current discussion is focused on the accumulation phase
of retirement planning. This is the first step, and many of us
are still trying to stash away enough capital just to call it a
nest egg! The trend toward individuals having to assume
responsibility for a significant portion of their retirement
income is relatively new, and we are still in the early stages of this experiment.
But for the sake of
those who are already retired or getting close, and to
provide some insight into the full scope of our retirement planning responsibilities, lets take a moment to discuss the hatching
phase. It turns our that sitting on the
nest egg is the easy part. The real work comes when we need to use it to
provide steady and dependable investment income. There are many new
challenges associated with investing for income and growth rather
than just growth alone. Saving and spending are two completely
opposite actions. So it stands to reason that when we stop
doing one, and start doing the other, some of the rules change.
Everyone has heard that when you
invest in stocks you want to buy low and
sell high. But what is not so well known is that buying low
is much easier than selling high. When buying stocks there is a nifty
little mathematical phenomenon that helps us out called dollar-cost averaging.
It is so natural that many people do it without even knowing it. All you have to do is purchase a consistent dollar amount of
stocks on a regular basis. So for example, if a stock is selling
at $50 one month and you buy 4 shares, but then it drops to $40 the next
month and you buy 5 shares, you wisely purchased more shares at the lower
price. In reality you maybe didn't do this on purpose. You just
decided to invest $200 each month---perhaps through
a payroll deduction. Over time this approach allows you to automatically purchase more shares at lower prices than at higher prices. Its like
stocking up on groceries when theyre on
Now consider this
important twist...if the dollar-cost averager automatically wins
in the market, does someone else automatically loose? The answer
is yes. And if you have any doubt, just ask the person
selling shares to the dollar-cost averager! Each time the
dollar-cost averager buys a lot of shares at a low price, someone
else has to sell a lot of shares at a low price---an obviously
less favorable situation. So why would anyone do this? Well, perhaps
the person selling shares is retired and needs income.
Here lies the major
peril of investing during retirement. The bumpy unpredictable
stock market actually helps the person saving for retirement, but is in direct conflict with providing steady and dependable income
during retirement. When accumulating capital an investor can
look at a down market as a time of opportunity---a time to buy
low. But during retirement the rules change. The mathematics that worked so well
before retirement take a nasty turn against you. This is because
more shares have to be sold whenever stock prices are low in order to maintain
the same level of income. It would be great if during retirement there was
a natural tendency to sell high in the same way that there is a
natural tendency to buy low before retirement. But
unfortunately this is not the case.
An extended down market during the
early years of retirement can be especially devastating if one is forced to
sell a significant portion of stocks at low prices to meet income needs.
Therefore it is risky to have everything tied up in stocks
during retirement, even though it can be tempting after a string
of good years, and even if this strategy worked well prior to
retirement. Still, stocks usually do
outperform other types of investments over the long-term. So most
retirees will need to invest in some stocks to keep up with inflation and to
ensure that capital is not depleted too soon.
The question then becomes...how much of ones portfolio should be in stocks vs.
something more certain like fixed-rate investments? This question
is usually followed by a rule-of-thumb that says something like,
"take 125 minus your age and invest this percentage of capital in stocks". But how much peace-of-mind does this
really provide? Is the magic number really 125? Isnt there a
better way to think this through?
Yes! When you decide
how much to invest in fixed-rate investments, what you are really
deciding is how long you could wait if necessary before selling
stocks. In effect you are giving yourself some time and breathing room in case
you encounter a down stock market. This way you can still meet your
income needs from the fixed-rate investments without having to sell your stocks at bargain-basement prices. The more you have invested in quality
fixed-rate investments, the longer you will be able to wait if
necessary before selling stocks.
Therefore why not plan for specific maximum
periods during retirement? The key to this is to purchase fixed-rate
investments with staggered maturities so that as they mature, the
principal and interest exactly meets your desired income needs
for the duration of the stock holding periods. This sounds more
complicated than it is. The gist is that you divide your
portfolio into two pieces. One piece is used to purchased
fixed-rate investments that provide regular income---much like the
paycheck you probably received while working. The other piece is
used to invest in stocks for the future---just like you probably
also did while working.
If your stocks do
well, great! Then you may want to consider selling some shares
to purchase additional fixed-rate investments, i.e. sell high. But if your stocks
get off to a rough start, at least your immediate income will be secure and
hopefully the market will improve before the end of your stock holding
periods. Eventually stocks will have to be sold to purchase additional
fixed-rate investments for income. But the key is to give
yourself some time, so that you can sell when you want to---not
when you have to.
This approach offers
many advantages. Your income will be guaranteed for a predetermined number
of years before having to sell stocks. You
will be able to continue to
participate in the stock market as a long-term investor, which along with
diversification are the keys to reducing stock market risk. You will be in
control of your plan rather than letting the markets be in control of
you. And most important you will have the peace-of-mind to fully enjoy
your retirement years.
includes much more than just investing capital for growth. The
ultimate goal is steady, dependable, and lasting income. This is a
challenge filled with many uncertainties. But with thoughtful plans that
include deliberate maximum stock holding periods, we can all balance the
competing needs of guaranteed income and long-term growth during retirement.
So next time you hear the nest egg metaphor,
remember, someday that bird is going to hatch...and hopefully