How to Reassess Your Portfolio at Retirement

Planning for retirement is a complex area and you may be interested in the best retirement planning books or financial advice before planning your own retirement. That being said, you should feel empowered to review your own investment portfolio at retirement. This article will explain what you can do at retirement to check that your investments are still working hard to support you in your golden years!

How to Reassess Your Portfolio at Retirement

Are you retirement ready?

In this article we’ll cover the following method of assessing whether your assets are ready to see you all the way through your retired years:

  • Calculate the minimum income you need, and check that your assets are capable of providing this.

Let’s look at how you can execute these retirement checks.

Budget your minimum income & check your margin of safety

This retirement check is the most essential. We ask ourselves the question: is my retirement pot enough? We calculate the minimum we need and measure how much safety margin our portfolio has. This safety margin is a crucial metric that could significantly impact how you save or invest your money and how cautious you need to be about spending.

First; create a budget of the essential expenses you’ll need to cover in retirement:

  • Any rent or remaining mortgage payments and council tax
  • Utilities & groceries

Don’t forget expenses which don’t appear often but will eventually:

  • Repairs & maintenance of your property
  • Replacing electronic devices & household appliances
  • Modest holidays

If you add all these expenses up, and add 10% for unforeseen expenses that life throws at us, this is your minimum income figure. It’s time to check how comfortably your investment portfolio can cover these basic needs.

Applying the 4% rule of thumb

The simple rule of thumb of how much retirement income an investment portfolio can produce is 4%. This means that every £100,000 of pension and retirement savings will allow you to withdraw £4,000 per year. This is deemed to be a sustainable level of withdrawal that will allow you to withdraw each year without running out of money.

A common misconception is that this ‘4%’ represents the income one can withdraw from a dividend investment portfolio without eroding your principal amount. This is not correct. The 4% rule assumes that you will withdraw interest and some capital. A moderate risk retirement portfolio will rarely generate a 4% dividend yield. Yes, a 4% yield or even an 8% yield is physically possible from equity investments, but usually at an intolerable level of risk for retiree. The issue with investment risk in retirement is that your money is now finite – you’re not making any more of it. Therefore the preservation of your investment has to take a higher priority.

Calculate your margin of safety

So you’ve budgeted your minimum retirement need. You’ve applied the 4% rule of thumb to understand the income level of your portfolio. All you need to do now is add other state or pension benefits to calculate your total income and check that this covers your minimum retirement need.

If you’ve saved at least 5% of your income across your career, your level of savings should be sufficient. The question is… how sufficient? Is your margin of safety small, adequate or huge?

  • 0 – 20% – Small margin of safety
  • 20% – 50% – Adequate margin of safety
  • 50%+ – Huge margin of safety

This is only a rough guide, but we’ll use these margins to demonstrate how your margin of safety should alter your mindset about retirement.

Small margin of safety (< 20%)

With a small margin of safety, you need to exercise extreme care with your retirement planning. Consider finding a financial adviser. A small margin of safety implies that even a small disappointment in your investment portfolio performance could impact your quality of life because it could take you below your minimum needs.

If you have officially retired and have no desire to rejoin the workforce to supplement your pension & investments with another income, then you may need to make a structural change to your finances in order to rebuild that buffer.

Everybody pictures their retirement as a period of easy-going days with ample time to explore hobbies and rebuild relationships. They don’t picture it as a period of anxiety over whether your income will cover the bare essentials, and whether you’ll be able to ever afford to go on a holiday again.

That’s why a rational response to a small margin of safety is to increase that margin as quickly as possible, either by reducing your fixed outgoings (for example, by downsizing your house to a smaller property with lower ongoing costs) or by finding another income.

Investors with a small margin of safety find themselves with a difficult choice regarding the risk of their investment portfolio. Because their quality of life is more dependent on their investment performance, this reduces their appetite for risk.

However, a lower-risk portfolio will produce less income and the 4% withdrawal rule may need to be downgraded to 3% to ensure that the pot won’t run out. However, this will instantly reduce income – the precise outcome we were trying to avoid.

An investor with a small margin of safety doesn’t have the capacity to take the risks needed to extract the most value from their portfolio. Meaning those who need their money to work the hardest, generally won’t be able to. It’s a dilemma.

Adequate margin of safety (20%-50%)

If you have a 20% – 50% margin then you are in a much more comfortable position. Even in a worst-case outcome where the target income of your portfolio delivers disappointment for an extended period, you may still have the capacity to continue to make the drawdowns required.

By living simply, you may find that your retirement portfolio actually remains stable or even grows over time.

This margin of safety may encourage you to take more risk with a higher allocation of equities in your portfolio which will increase its expected return over the long run. It’s a win-win.

Huge margin of safety (50%+)

A huge margin of safety is an odd position to find yourself in. Either you want the excess cash to live a luxury lifestyle and spend large on experiences and loved ones to make the most of the time. Or, you worked for many more years than you actually needed to! Read our guide about how to retire early to understand what indicators suggest that you’re able to retire early.

Because your investment portfolio is surplus to requirements, you have two options available:

  • Maximise risk to increase the amount of wealth that you can gift or pass onto loved ones
  • Minimise risk to remove investment risk totally from your radar for the rest of your life.

The more wealth you have, the less risk you need to take. The option at the extreme bottom end of the risk spectrum is to buy an annuity from a life assurer and received a guaranteed income for life. This may only be feasible for those with a high margin of safety because annuity rates are currently very low, and therefore many retirees cannot afford to swap their investments for a low-paying annuity while still meeting their income targets.

How to assess if your retirement portfolio is retirement ready

Investors often ask what a retirement portfolio should look like. The answer depends upon how long you think your portfolio will need to last, how large is your margin of safety, what is your risk appetite and how keen are you to need to tinker and trade during your retirement years.

Here is an illustrative retirement portfolio for the start of retirement:

  • 50% Equities
    • 20% Ex-UK large cap
    • 16% UK large cap
    • 7% Real Estate Investment Trusts (REITs)
    • 4% UK small cap
    • 3% Emerging markets
  • 50% Bonds
    • 40% Corporate bonds
    • 10% Government bonds

You will notice that this portfolio contains a moderate amount of risk. The equity allocation is still substantial, and it even includes an investment in emerging markets. (Not to be confused with investing in frontier markets).

That’s because a retiree at the age of 65 could easily live for another 20 years. Therefore when using the ordinary principles of portfolio management, we can afford to take risk because the time horizon allows plenty of time for recovery of the portfolio.

That being said, the portfolio is not aggressive. This reflects the reality that constant withdrawals from your pension mean that different slices of your portfolio will have much shorter time horizons. I.e, 4% of your portfolio will be withdrawn next year, 4% the year after that. For this wedge of short term withdrawals, equity investments would be inappropriate as you may be forced to sell equities after a downturn simply to meet your income needs.

This is why retirement portfolios with 80%, 100% equity allocations are rarely seen in the wild.