How to structure your income in retirement

The financial and investment world is prone to both overcomplicating simple matters and oversimplifying complex matters. Nowhere is this more apparent than in the retirement space, in which concepts such as determining your risk level based on your age or always drawing the same percentage of capital every year are seen as foolproof or 'guaranteed' plans.

Retirement is not a linear process, and it resists being easily modelled. However, some broad approaches are worth highlighting.

The 4% rule

The 4% rule suggests that you can safely withdraw 4% of your savings each year in retirement for at least 30 years.

This 'rule' is really more of a generalisation - it is not meant to work for everyone. The 4% rule was roughly premised on the common 60:40 asset allocation: 60% shares and 40% bonds. This asset allocation tended to help investors because shares and bonds were negatively correlated: when one performed poorly, the other made gains, buttressing the portfolio. It was never intended for one number to represent the experience of so many different individual retirees, but the media ran with the term and made it a famous 'rule'.

The Down Under version - the 5% rule

At our retirement advisory firm, Wattle Partners, we have come up with our own rule of thumb. Our experience has shown that a broadly diversified balanced portfolio, with share allocations evenly split between global and domestic, should be expected to provide an income yield of 5% a year in retirement.

A key part of this is the higher yields of Australian shares, driven by the history of franking credits, but also franking credits themselves. Australia's tax system is unique in that franked dividends are taxed less harshly than capital gains, which is the opposite of that which occurs overseas. The result is that, over many years, Australian companies have tended to focus on paying higher dividends to attract more investors and thus ensure their share prices remain supported. This means that if you rely solely on overseas shares, you will be forced to draw into capital regularly given the lower yield from most investments.

This rule of thumb is intended to give you confidence that the income will come over the long-term,so that you can focus on living your life rather than focusing on every dollar deposited into your bank account.

Filling your buckets

Another common approach to saving for retirement involves setting up 'money buckets' that split your savings into three sources:

1. The short-term bucket holds six months of your living expenses and income requirements in cash and highly liquid term deposits. It is your main, immediate financial buffer.

2. The medium-term bucket contains three years' worth of living expenses and income requirements in high-quality, low-to-medium-risk assets such as government bonds, credit, property, infrastructure and some blue-chip shares.

3. The long-term bucket is dominated by stocks and other growth assets, such as real estate investments. This part of the portfolio is likely to deliver the best long-term capital growth, but the returns in this bucket will vary more than the other two buckets.

The buckets are refilled by interest income, dividends and other gains from your investments. At some point each year, the buckets need to be rebalanced. Our experience has shown this should occur once a year at the very least, but the optimal rebalancing period is every quarter in order to gain the benefit of dollar cost averaging.

The logic of the bucket strategy is that regardless of the short-term performance of the long-term bucket, pension payments can continue from the other pools without you having to sell down the growth assets at potentially unfavourable prices. As your short-term cash needs are covered, you won't have to worry about the fluctuations in the stock market.

This is an edited extract from The Golden Years: How to plan a happy and financially secure retirement (Major Street Publishing $32.99), republished with permission.