And you know what? He's right. It can get complicated.
For a 40/60 portfolio, for example, do I allocate 40% of my total assets to equity or 40% of my liquid assets? Do I include my home equity? A pension or Social Security benefits? How about a fixed income annuity?
An often-asked variation of this question is whether home equity should be included when calculating "sustainable withdrawals".
I suggest the following to make it more clear. Divide all of your assets into three portfolios.
The first, which I'll call the non-retirement portfolio, will contain any investment assets that you choose not to be used to fund your retirement. Your home equity will probably go into this portfolio. If you plan to keep your house and leave it to the kids or to a charity in your will, it goes here.
The non-retirement portfolio will also include money you set aside for your heirs, antique cars, works of art, college savings and any other investment asset that you do not plan to convert to cash to pay for your retirement. Illiquid assets should go here unless and until you convert them to liquid assets. Liquid assets can go here if you don't plan to spend them to fund retirement.
Notice I say that assets go here that you choose not to use to fund retirement. Unless you put the assets in a trust, you can change your mind, move them to another portfolio and spend them later in retirement. This is little more than a "hands-off" sign for assets you hope you won't have to spend for retirement expenses, but that will be there if you need them.
The second portfolio, which I'll refer to as the "floor" portfolio, will contain any asset that will generate retirement income but is not exposed to either market risk or interest rate volatility. This will include Social Security benefits, pensions and fixed income annuities (and probably TIPS bond ladders, though they need further discussion). These sources will provide the same amount of retirement income whether the market sinks or rises and whether interest rates rise or fall. This portfolio will provide a relatively safe floor of retirement income no matter what happens to the stock and bond markets. (I wrote about floors in Unraveling Retirement Strategies: Floor-and-Upside.)
The third portfolio, which I'll refer to as the retirement income portfolio, will contain all assets that you intend to use to fund retirement and that are exposed to market risk and/or interest rate risk. The stream of spending created by the retirement income portfolio (due to the unfortunate acronym, I won't refer to it as the RIP) depends on stock and bond market returns and is risky. Diversifying among multiple stock and bond asset classes helps manage this risk.
I'll make one last point about portfolio contents regarding our homes because it is often a subject of confusion. I initially put the home in the non-retirement portfolio under the assumption that the retiree would keep the house throughout her lifetime. (Surveys show that's what most older American hope to do.)
But, as I mentioned above, these non-retirement assets can usually be accessed for retirement income if you need them. The equity in a home can be transferred to the retirement income portfolio as cash if you sell the home. Also, the equity can be transferred to the floor portfolio if you take out a reverse mortgage. So, there are ways for your home to provide retirement funds that you can spend, but you have to sell your home or use it as collateral before that can happen.
If you have no plans to downsize or take a reverse mortgage, your home won't be a source of retirement income and should not be used in the sustainable withdrawal rate (SWR) or retirement income asset allocation calculations.
Back to our three portfolios, let's consider their very different natures.
The non-retirement portfolio has no retirement spending rate because you have chosen not to spend from it. The investment horizon may vary for each asset. A grandchild's college costs may need to be covered in three years while investments for heirs may not be spent for decades. Depending on its contents, the non-retirement portfolio may be exposed to market and interest rate risk. Unless the assets are in a trust, you can probably transfer their value to the retirement income or floor portfolios later in retirement. Asset diversification may be beneficial in the non-retirement portfolio, but it isn't linked directly to your retirement income portfolio allocation.
(The non-retirement portfolio isn't completely irrelevant to the retirement income plan. If you have a lot of non-retirement assets, you can take a little more risk with your retirement income strategy, knowing you have these other assets available as a backup in a crisis. If your non-retirement portfolio is empty, you need to be even more careful with your retirement income portfolio asset allocation.)
The floor portfolio, in contrast, provides income that is critical to our standard of living. The assets in this portfolio are not exposed to interest rate risk or market risk. (The exception to this is a bond ladder which I will discuss in a separate post.) Though diversifying among Social Security benefits, pensions and fixed annuities might be beneficial, it is rarely practical. The spending rates for these assets are fixed by the Federal government for Social Security benefits, our pension provider, or the insurance company that sold the fixed income annuity.
Lastly, the retirement income portfolio will have a spending rate, assuming the floor portfolio doesn't cover all of our expenses. It will typically be in the 3% to 4% range of remaining portfolio assets. The assets in this portfolio are exposed to interest rate risk and market risk. The investment horizon is laddered: we will have short term needs, long term needs until the end of our life, and everything in between.
The following chart summarizes the differences between the three portfolios.
So, back to our original questions, which assets are included in the percentages for calculating sustainable spending amounts and asset allocations? The answer is the total assets in the retirement income portfolio. If we move assets from one of the other portfolios (our home equity, for example) into the retirement-income portfolio in the future, we recalculate then.
Which portfolio assets can we move in the future? We can move non-retirement assets or retirement income assets into either of the other two portfolios, though we may have to convert the asset to a liquid form (usually meaning cash) before we do.
Moving out of the floor portfolio is more difficult. We can't move Social Security benefits. Moving a pension or an annuity would mean selling it for what is typically pennies on the dollar and is usually cost-prohibitive. Bonds can be moved to either of the other two portfolios, subject to interest rate risk.
These are important things to know when we are developing a plan. Some parts of the plan can be changed to adapt to changing circumstances over time, like our asset allocation, our spending rate and which assets we hope to bequeath to our heirs and which will we use to pay our own bills.
Other parts of the plan are very difficult to move once executed, typically prohibitive to undo, like changing a Social Security benefits claim or converting a pension or fixed income annuity into cash.
As an example of the asset allocation calculation, if we have $100,000 home equity in the non-retirement portfolio and $200,000 in the retirement income portfolio and would like a 40/60 retirement portfolio allocation, we would invest $80,000 in equities and $120,000 in bonds, ignoring the home equity. How would we allocate the $100,000 of non-retirement portfolio assets? That depends on our goals for those assets, but it may be very different than 40/60.