The Two Phases of Retirement Planning

“How do I invest in retirement?” If you’ve heard me speak before, I’ve highlighted the fact that there are two distinct phases when it comes to retirement under this retirement planning advice umbrella. There’s phase one, the “accumulation phase,” the saving and investing phase of retirement. Once you make the retirement transition, you’ve now entered phase two which is the income phase. Here, you’ve built retirement savings, and now in the income phase, you’re using those assets to enjoy a lifestyle in retirement.

Could your Investment Strategy Look Similar Pre and Post Retirement?

The reason I bring that up is because the investment approach, your strategy when it comes to your investments in this accumulation phase, is distinct. But I’ll explain shortly how this investment strategy really shouldn’t be that different when it comes to the income phase in retirement. The way that you invest in phase one and phase two really should be pretty similar. We’ll come back to this idea.

What is Risk Tolerance?

But first, let’s talk about the accumulation phase when we are putting together a strategy for how we want to invest our assets being saved for retirement. A lot of this is built on the idea of risk tolerance, meaning how much volatility can I stomach and handle on my investments for the potential growth that can provide. If I can’t stomach a whole lot, I don’t like seeing big swings, then I’m going to prefer less risk. My returns are obviously going to be reflective of that lower risk that I’m taking. If I am okay with the ups and the downs, then I am willing to take on more risk leading to more exposure to equities or stocks. These assets will be positioned for greater growth potential.

Determining Your Own Risk Tolerance

As investors in this accumulation phase, we determine our risk tolerance in two ways. The first determining factor will be driven cognitively – what we know and understand about investing in general. The second factor will be our own behavior when we begin investing. Oftentimes when we get into investing and begin doing it, we realize, ‘Man, money is powerful.’ It drives emotions, and having a volatile portfolio may draw out a deeper understanding of ourselves when we actually get in the game and begin doing it. So, risk tolerance is both a cognitive and an emotional assessment of how we can handle risk in this accumulation phase.

Assessing Risk Tolerance in Retirement

I’m going to argue that this assessment really shouldn’t be any different when it comes to the income phase of retirement and I’ll explain why. If you’ve followed the 4Buckets, you understand that as we work through Buckets One, Two, Three, and Four, we are building out a retirement income that is largely built on guarantees and certainty. We understand that as humans and as investors, we prefer safety, guarantees, and consistency, and that’s exactly what we want to build out through the 4Buckets strategy.

Buckets Two and Three: these are going to be our main income engines to build out our 4Buckets Lifetime Income. As we build that out and we establish a retirement income in line with a retiree’s lifestyle, we are now in a much better position to approach the question, “How do I invest in retirement?” Again, what we’re trying to do with the 4Buckets framework is recreate a lot of the same characteristics from the accumulation phase, in this income phase.

Your Younger Investor Self

What are some of those characteristics? Well, characteristics being the preference for a steady salary during your working years. We prefer an option of a higher base salary when looking at total compensation. To restate, I’m going to prefer a job that gives me a higher base rather than a job that’s going to give me perhaps the same overall compensation but with a lower base salary. Additionally, we’re going to prefer to have a solid cash cushion. That’s been an integral part of your financial planning leading up to retirement. Having enough in cash and in reserves to be able to weather unknowns as they come through life.

And then finally, we want to be able to approach investment strategy with a clear head. So, if we have solid cash, we have a good income cushion, that is going to help us approach our investment strategy with clear eyes, and that’s exactly what we’re doing with this 4Buckets framework: Bucket One, we’re building out that cash reserve cushion. Bucket Two and Three is where we’re establishing this 4Buckets Lifetime Income, establishing a guaranteed income base that aligns with your lifestyle. And so, when we then step into Bucket Four and look at residual retirement assets that are not directly being used for your ongoing lifestyle in retirement, we can now ask the question, “How do I invest my money?”

How to Invest Extra Dollars

Well, like I said, we want this to replicate accumulation, and so in a lot of ways, the conversations that we have with retirees are not that much different around how they should invest. We’re looking at time horizon – a common idea when we think about the investment strategy, meaning, ‘how long until I absolutely need this money?’ Bucket Four money and assets should have a fairly long time horizon. This money is going to be used for periodic enjoyment in retirement, it’s going to be earmarked for potential healthcare expenses later in life, and then finally, anything that’s left is going to be a legacy to family or to charity, if that’s a motivation for the retiree that we’re talking with.

All of these speak to a longer-term time horizon, so that checks the box on being able to position assets for greater growth. We’ve again established good cash and a solid income through the 4Buckets framework, so in theory, we should be willing to position assets for greater growth potential. At the same time, we understand that age and cognitive ability actually work against us as we age when it comes to dealing with money decisions and dealing with emotions around money.

Investment Options for Growth Potential

So the way that we approach the investment conversation is working with a retiree within our 4Buckets framework to create balance across residual assets that will help them position as much of their assets as possible for growth. In our minds, from a traditional standpoint, equities, stocks, stocks mutual funds, and stock ETFs, are going to be the best opportunity for everyday retirees to achieve growth.

Finding the Right Investment Balance

And so we want to work with the retiree to figure out an appropriate balance that’s going to allow them to put as much of their extra assets in this growth bucket as possible. What does that mean? Well, oftentimes, it’s actually going to mean looking at both Bucket One and Bucket Four to determine that balance. Bucket One is our cash reserve bucket, and at a minimum, we want to have six months of our lifestyle stored up in Bucket One. But we quickly see that number go higher when we’re working with a retiree trying to figure out this appropriate risk balance.

Retirees prefer cash; they prefer safety, and so when we’re looking at extra assets, we’re trying to figure out how much we can put in Buckets One and Four to figure out that spot where retirees are going to feel comfortable about the income they have and the investment approach they’re taking. The last thing that we want to do is overweight one or the other and the retiree is dissatisfied. They’re either dissatisfied with the low yield that they’re getting on too big of a cash reserve stockpile, or they’re bummed out with the lack of gains that they’re seeing in Bucket Four. These responses show an imbalance that needs to be addressed and so that’s what we’re trying to do: to figure out what that balance is.

Achieving Clarity Around Risk

Oftentimes when we look at it through this lens, we’re then able to say with much greater clarity, “These are my growth assets and these are my reserve assets.” And so, when we’re asked this big question that we’re always asked as retirees, “What is my risk tolerance?” – by going through the 4Buckets framework, we can answer that question much better.

“What’s Your Risk Tolerance?” Right Idea, Wrong Timing

To review, we’re trying to have the accumulation phase and the income phase look fairly similar when it comes to investment strategy. But, what is important is that we don’t answer the risk tolerance question first. We’ve talked about how the dominant approach to retirement planning today is using an investments-only strategy. This is a probability-based strategy where you’ll be asked the question right off the bat, “What’s your risk tolerance?” The answer to this question under prevailing advice will drive the sort of allocation you should have on your entire nest egg.

Risk Comes Later

That is not the approach that we take with the 4Buckets. The 4Buckets uses both certainty and risk to create a retirement income strategy. We’re going to work through Buckets One, Two, and Three to establish retirement income and then approach extra assets and ask this question, “What is the investment strategy? How do I invest my assets?” But we come to that question much later in the process after we’ve worked through the preceding steps.