Generating a Paycheck From Your Nest Egg

You are no longer an accumulator; you are now a decumulator. This is a completely new phase. It needs to be thought through carefully. Too often people retire in a rising market with no thought given to how they are to fund their retirement. Then the market drops and the problems start.

Think it through ahead of time. You are no longer building up your nest egg by making your 401k contribution out of your paycheck every two weeks. Now you are looking to the nest egg to provide a paycheck.

There are a number of ways to proceed. DIY Investor believes that the decumulator should first put 9 months of payments into a short-term fund. This is where the paycheck will come from. This is the primary defense against a market downturn. It enables you to weather a market drop.

It is important to have this plan in place to minimize the chances of selling stocks or bonds after they have dropped significantly in value. If you think about it, just systematically selling in a down market is the opposite of dollar cost averaging - the process that was so instrumental in building the portfolio up. Avoiding this "negative dollar cost averaging" is important in managing the nest egg in retirement.

Part 2 of the plan is to seek to structure the portfolio so that at least 60% of income needs is met by dividends and interest payments of the portfolio.

Here is a simple Excel table for one of my retired clients:

 CLICK TO ENLARGE  Note that this client only invests in ETFs. As an aside, for those seeking solid dividend paying stocks, there are blogs that do a lot of really good analysis on dividend stocks. For example, The Dividend Pig offers a list of stocks with an accompanying analysis along with a list of other bloggers who analyze dividend stocks.

In the table, notice the bottom line is in the right hand corner, $10,405. Divide this by .60 and get $17,341. This is the amount that the portfolio can easily provide and weather a market downturn. Also notice the portfolio yield, 2.42% which is key.

If $17,341 isn't sufficient, then more assets have to be directed to dividend paying stocks. That can be done, but always keep an eye on risk. Notice that in the portfolio above, DIY Investor could easily sell the small stock ETF and add a dividend ETF and at the same time reduce one type of risk. It, of course, reduces the expected return on the portfolio.

What are the dynamics? Simply, if the return on the overall portfolio is less than 7% (7% is a target return - it was the assumption used in figuring out if she had enough to retire on), feed the dividend and interest income into the short-term fund from which the paycheck is generated. Otherwise, if the return is higher, reinvest the proceeds. The IRAs, of course, present a challenge because their withdrawals will be taxed and they have to start to be withdrawn at 70 and 1/2.  But at this time, also, the yield on the portfolio will likely be higher because the allocation to bonds will be greater and probably yields will be higher. Still, it is worth thinking about.

The table shown above doesn't take long to do. If you are not familiar with Excel, find someone who is - possible a high school student.  Especially, if you are within 5 years of retirement, this will begin to give you a handle on meeting your income needs whether you use the strategy described here or one of your own.