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Personal Finance

How Should Retirees Invest a Lump Sum in a Lofty Market?

A windfall will save their retirement, but elevated stock and bond prices give this couple pause.

Jim and Ellen's biggest retirement asset was right under their nose.

Jim, 77 and a retired contractor, and Ellen, a 73-year-old retired retail executive, are enjoying married life--a second marriage for both of them--and looking forward to retirement as a couple. Jim notes that he "inherited" three great children when he married Ellen, and they now have six grandchildren, too.

Jim continues to work part-time in retirement, but their lack of substantial retirement savings was a nagging worry: "As a longtime bachelor and child of the '60s," Jim wrote, "I spent many pleasurable decades living in the moment and never thinking about, much less planning for, the future." Ellen is more of a saver by nature, but raising three children on her own left little room in her budget for retirement savings. Her retirement assets totaled about $85,000.

But serendipity came to the rescue. A seaside home they purchased and renovated together--which Jim describes as "the worst house in a beautiful neighborhood" has appreciated nicely since purchase. "We found ourselves decades later with a greatly appreciated asset and a familiar buyer who only wants a real estate investment and will let us stay in our home and rent it."

After closing, Jim and Ellen will have $660,000 in cash, along with Ellen's retirement assets and a small Social Security check per year. Together, those funds will go a long way toward tiding them through another 20 years or so of retirement, especially given that the couple's expenses are pretty modest.

The big question, however, is just how those funds should be invested given a lofty market environment. Jim laid out the conundrum well: "Here we are with the stock market close to an all-time high, the bond market paying historically low interest, and savings, money market, and CDs also paying next to nothing in interest."

Jim and Ellen also differ in their investment philosophies. Jim would like to invest in socially responsible companies that align with his belief system, but that's not a priority for Ellen. "She thinks we need to maximize what we can grow with every dollar," Jim explained.

The Before Portfolio

Before the home sale, the couple's portfolio consists of a $25,000 cash sleeve as well as Ellen's retirement accounts: a Roth IRA and a SEP-IRA. Her Roth is primarily invested in equity funds from American Funds. Her SEP-IRA features a variety of mutual funds from American Funds as well as investment boutiques like DoubleLine, Artisan, and Royce. Although a number of Ellen's holdings are Morningstar Medalists, her portfolio also includes several funds with Morningstar Analyst Ratings of Neutral.

With the home-sale proceeds included in their asset allocation, the bulk of their Before Portfolio is in cash.

The After Portfolio

Job one with any portfolio makeover is to test the viability of the overall plan--in this case, whether Jim and Ellen's portfolio is sufficient to support their spending rate. They estimate that they'll spend $36,000 from their portfolio annually, after accounting for Social Security. That amounts to a 4.7% annual spending rate, given their $770,000 portfolio after the home sale. That's over the 4% threshold that retirement planners often recommend as being safely sustainable, and well over the roughly 3% threshold that some retirement researchers have suggested is safe given today's low bond yields. Nonetheless, the fact that Jim and Ellen have been retired for a while--and therefore their spending horizon is a bit shorter--puts 4.7% in the right ballpark.

A bucket approach can help allay their concerns about sinking a lot of money into the market at an inopportune time. They can hold a few years' worth of portfolio withdrawals in cash investments, another five to eight years' worth of withdrawals in bonds, and the remainder in a globally diversified equity portfolio.

Because Ellen's SEP-IRA is subject to required minimum distributions, I started by bucketing that portion of portfolio. Although yields are low, my After Portfolio steers two years' worth of RMDs into cash and another eight years into high-quality bonds. Because Ellen needs ballast with her bond holdings--funds that will hold their ground if equities sell off--I employed the Silver-rated American Funds Bond Fund of America ABNFX, an intermediate-term core bond fund, in place of DoubleLine Total Return Bond DBLTX, which is in the core-plus bond Morningstar Category. (Core-plus bond funds generally have slightly higher returns but with more volatility and risk than core bond funds.) I also added a component of short-term Treasury Inflation-Protected Securities to this portion of the portfolio. Together, those cash and bond positions will provide roughly 10 years' worth of RMDs. The remainder of her SEP-IRA can go into a globally diversified equity portfolio. The Before Portfolio was light on foreign stocks, so I increased that weighing throughout their portfolios. On the U.S. equity side, I focused on the highest-rated options in the Before Portfolio. I tilted toward value to offset the slight growth bias in their taxable portfolio.

Ellen's Roth IRA can reasonably be invested in equities because she won't likely tap that account anytime soon. Because it isn't a big account, a single world-stock fund, American Funds Capital Word Growth & Income CWGFX works well here.

I used the same general bucket framework for the taxable/nonretirement assets that Jim and Ellen will be bringing into their portfolio following the home sale. That portfolio, combined with the RMDs from Ellen's SEP-IRA, includes enough cash and bond assets to supply them with 10 years' worth of portfolio withdrawals.

I started by setting aside cash, noting that they'll be drawing about $32,000 a year from the taxable portfolio, in addition to Ellen's RMDs. For the remainder of the portfolio, my goal was to thread the needle between Jim's environmental, social, and governance preferences and Ellen's concern for costs and performance. I employed ESG bond ETFs, as well as a fund focused on short-term TIPS. (U.S. Treasuries typically pass muster from the standpoint of ESG considerations and in fact dominate many ESG bond funds.) Jim and Ellen could also purchase $10,000 of I Bonds apiece. I didn't worry too much about the tax efficiency of this portion of the portfolio because yields are low, and with some planning, the couple should be able to stay in the 12% tax bracket.

I steered the equity holdings into Vanguard ESG index funds that provide broad market exposure and mild ESG characteristics at a very low price. These funds use an exclusionary approach, meaning that they avoid companies with undesirable ESG characteristics--most markedly, their energy exposure is very low. That tends to give them a bit of a growth bias relative to the broad market, but over time their performance should track that of their underlying indexes quite closely. Of course, if Jim and Ellen decide to go with non-ESG total market index holdings for this portion of their portfolio, they could bring their portfolio's costs down even further. Both the ESG and non-ESG index trackers are likely to be quite tax-efficient over time.

Editor's note: This version of the article has a corrected asset allocation in the After portfolio. Names and other potentially identifying details in portfolio makeovers have been changed to protect the investors' privacy. Makeovers are not intended to be individualized investment advice but rather to illustrate possible portfolio strategies for investors to consider in the full context of their own financial situations.

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