Time Segmentation, a Smart Way to Invest Retirement Money
A Smart Way to Allocate Retirement Money
Time segmentation is a strategy you can use to invest for retirement. It involves a process of matching your investments up with the point in time when you will need to withdraw them to meet your retirement income needs. Let's look at an example.
Let’s assume Harry and Sally are age 60. They plan to retire at 65. They want to know their first ten years of retirement income are secure. If they use a time segmented approach, they might buy CDs, bonds, or fixed annuities (or a combination of these things) in amounts designed to mature and be available in the year they would need them.
Example of Time Segmentation in Action
Suppose Harry and Sally know from ages 65 – 70 they will need to withdraw $50,000 a year to cover their living expenses. They find a series of CDs and bonds earning 2% to 4% to mature in the years they need the money. This is referred to as a laddered bond or laddered CD strategy. It would work as follows:
- CD 1 paying 2% - matures at Harold’s age 65
- CD 2 paying 2.5% - matures at Harold’s age 66
- Bond 1 paying 3% - matures at Harold’s age 67
- Bond 2 paying 3.5% - matures at Harold’s age 68
- Bond 3 paying 3.75% - matures at Harold age 69
- 10 year fixed annuity paying 4% - matures at Harold’s age 70
- Bond 4 paying 4% - matures at Harold’s age 71
- Bond 5 paying 4.1% - matures at Harold’s age 72
- Bond 6 paying 4.15% - matures at Harold’s age 73
- Bond 7 paying 4.2% - matures at Harold’s age 74
Using the schedule above, in the bullet points below I have shown the required investment needed at Harold’s age 60, for the investment (including the interest it would earn) to deliver the needed $50,000.
- CD 1 paying 2% - $45,286
- CD 2 paying 2.5% - $43,114
- Bond 1 paying 3% - $40,654
- Bond 2 paying 3.5% - $37,970
- Bond 3 paying 3.75% - $35,898
- 10 year fixed annuity paying 4% - $34,601
- Bond 4 paying 4% - $32,479
- Bond 5 paying 4.1% - $30,871
- Bond 6 paying 4.15% - $29,471
- Bond 7 paying 4.2% - $28,107
Total needed: $358,451
Let’s assume Harry and Sally have an IRA, a 401(k) and other savings and investment accounts totaling $600,000. After using some of their savings to cover the time segments above (which corresponds with their first ten years of their retirement) that leaves them with $241,549 left. This portion of their savings and investments would not be needed for 15 years. If they invest it all in equities (preferably in the form of stock index funds), assuming an 8% rate of return, it would grow to $766,234. I call this the growth portion of their portfolio. In years where the growth portion does well, they would sell some of their equities and extend their time segment. By continuously doing this they can always look forward seven to ten years knowing they have safe investments maturing to meet their expenses. They have the flexibility to sell growth in good years and give it time to recover when it has a bad year.
Notes About These Calculations
In these calculations, I am assuming all interest could be reinvested at the stated rate, which in reality is often not possible.
Also, I am not accounting for inflation. In reality, Harry and Sally would need more than $50,000 in five years to buy the same amount of goods and services that $50,000 would buy today. I could inflate the $50,000 needed each year by 3% for the number of years until it was needed, then subsequently discount it back by the return on the respective investment to be used. You would need to do the math based on your own personal needs and assumptions about inflation.
If Harry and Sally are delaying the start of their Social Security until 70, the income needs from their investments may not be exactly $50,000 each year. They may need more early on, and then less once their maximum amount of Social Security begins. They can use a retirement income plan timeline to chart this out and line up their investments to their needs.
Benefits of Time Segmentation
When you use a time segmented approach, you do not need to worry about what the stock market did today, or even what it does this year. The growth portion of your investment portfolio won’t be needed for fifteen years.
Time segmentation is quite different than the traditional approach of asset allocation with systematic withdrawals. A traditional asset allocation approach specifies what percentage of your funds should be in cash, bonds, and stocks based on how much annual volatility you are willing to experience. Then you set up what is referred to as a systematic withdrawal plan to sell so much of each asset class each year (or each month) to meet your retirement income needs. With a time-segmented approach annual volatility is irrelevant to your goals.
Learn More About Time Segmentation
In my article Is Reliable Retirement Income Worth 10 Minutes of Your Time I provide another example of time segmentation and a link to a short video that does a great job of explaining the concept.
A similar concept to time segmentation is that of using different buckets of money which is discussed in the book Buckets of Money. Conceptually I agree with the ideas in the book, but I don’t necessarily agree with the investments they recommend you use to fill up each bucket.