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By John Rekenthaler | 06-20-2014 11:00 AM

Falk: Immunize Your Retirement Portfolio Before Optimizing

Focus Consulting's Michael Falk suggests retirees pare down their fixed liabilities in their total portfolio so that they can make their discretionary spending much more manageable.

John Rekenthaler: I'm John Rekenthaler at Morningstar, and I am with Michael Falk, a partner of Focus Consulting Group and partner and strategist at Mauka Capital. Michael, thanks for joining us at the Morningstar Investment Conference.

Michael Falk: It's pleasure John. Thank you.

Rekenthaler: You [talked] about something a little different than we normally get at Morningstar Investment Conference.

Falk: I thought we'd have a fun day and a half talking about assets and portfolio management, and when it comes specifically to retirement planning, people are going to be much better off and more successful if they manage their liabilities not their assets.

Rekenthaler: So we have asset managers here, but you are talking about liability management?

Falk: Yes. Specifically, it enables the asset management in a way. If you think about liability management, lower debt as an example, lower fixed bills or expenses every month as compared with your total spending, Social Security, pensions maybe a laddered bond portfolio can cover that with virtually zero risk. Those fixed expenses.

As those are a smaller portion of your total spending that means everything else is more discretionary, which means that if you do take additional risk within your asset management and the market takes a nasty spill, it doesn't affect your lifestyle. And that's the beauty of this type of strategy, which I refer to as you should immunize before you even try to optimize.

Rekenthaler: We at Morningstar, including me, spend a lot of time writing about asset management strategies during retirement. Should you withdraw at a 4% rate or should it be 3% now? The numbers change, and we have these discussions going. Should you have more equities or less equities? And what you are saying is that's all fine in a way, but you could likely make this moot if you control your liabilities entering retirement. So you don't have to worry so much about generating that much income.

Falk: That’s absolutely correct. Whenever we make assumptions, what we know is that we raise some potential risk because it's uncertainty, and we don't know what's going to happen. If you would start withdrawing 4% every year and your spending rises maybe because of health-care needs, or the market goes down, that could really disable your overall asset picture and the future of your retirement planning. It's not that 4% is wrong, but if we start from a base of immunizing or planning for fixed expenses to be covered and then everything above that is discretionary expenses, well then risk can happen, and it doesn't disrupt.

So what I advocate is maybe start little bit more simply, maybe start with looking at how the total spending plan splits into both the budget for fixed expenses and in the balance of the spending plan for all those discretionary things that you love to do. Then once you get to a point of covering your fixed expenses, and if you go into retirement with little debt--the house is paid off and maybe you go down to one car that is paid for--you make that so much more manageable. Now you can roll with the markets punches so much more easily. It also means that there is no preset amount of equities that you should or shouldn't own. It also means there is not a preset amount of liquidation 3%, 4% that you should take every month.

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