About to retire? It's all about the 'safe money'

NEW YORK (CNNMoney.com) -- Big stock-market drops can be a boon for the young since they get to buy low and then let their investments grow for decades.

But when you're about to retire, steep drops like the kind we've seen in the wake of the subprime debacle seem less like buying opportunities than harbingers of under-funded days in your near future. After all, you're probably thinking about selling stocks, not buying more.

Certified financial planner Steven Kaye doesn't get rattled for his soon-to-retire clients when the Dow takes a dive. "To us, it's completely irrelevant," Kaye said.

That's because Kaye, who is president of the American Economic Planning Group, divides their portfolios into two components: short-term and long-term. The long-term is the part you leave in stocks and other higher risk investments. It's the short-term portion that will be your "safe money" -- the money that gives you peace of mind whenever stocks go awry.

For his clients with an aggressive risk tolerance, he makes sure they have five years' worth of cash flow in fixed income. For clients with a moderate risk tolerance, he sets aside eight years' worth. And for the conservative, he makes it 10, more if they're ultra-conservative.

Say you want to live on $100,000 a year in retirement. If Social Security and pension benefits provide $40,000, you'll need to produce the other $60,000 from savings. For aggressive investors that means parking $300,000 ($60,000 x 5 years) in "safe money" while conservative investors would set aside $600,000 ($60,000 x 10 years).

That "safe money" is then broken into three pots. Kaye keeps at least two months' worth of expenses in a money market account, and the rest in both taxable and tax-free bonds.

Currently, half of the taxable bond money goes into foreign government bond funds and Treasury inflation-protected securities (TIPS). The other half is put in one-, two- and three-month Treasurys.

If you don't want to deal with individual bonds, Kaye recommends using Vanguard Intermediate Term Bond Fund (Charts) (VBIIX), the tax-exempt Vanguard Limited Term Bond Fund (Charts) (VMLTX) and the Nuveen High-Yield Muni Bond Fund (Charts) (NHMAX).

He also likes super money market accounts - which typically require a $25,000 minimum deposit - since they pay about as well as ultra-short term Treasurys these days and carry virtually no risk.

Besides insulating retiring clients from big stock declines, "safe money" also can help them take advantage of any downturns when they do occur.

Kaye rebalances clients' portfolios whenever any portion increases by 5 percentage points more than originally allocated - e.g., if he wants 15 percent in one type of bond, and it increases to 20 percent, he'll take the extra money and reallocate it to parts of the portfolio that yield the most value at that time. When stocks are way down, "it means we're having a sale," Kaye said.

Especially when you're newly retired, you don't want to withdraw too much every year since you want to have enough in future years to accommodate inflation, taxes and unexpected expenses.

As a general guideline, Kaye said, "those who stick to a 3 percent to 4 percent withdrawal rate tend to do fine because they're not living beyond their means."

So for every $1 million in your portfolio you don't want to take out more than $40,000 in your first year. If you assume 3 percent inflation, in your second year, you shouldn't take out more than $41,200.

To figure out the best withdrawal rate for his clients, Kaye calculates their anticipated retirement expenses (including the possibility that they may move) and estimates their expenses will rise 3 percent a year due to inflation. He further assumes that their portfolio will grow by a modest 5 percent. To accommodate the need to take out increasing amounts every year because of inflation, he recommends a withdrawal rate that is less than what your portfolio earns in a given year.

That way, "your plan should have more than enough cushion for (a stock downturn)," Kaye said.

For those with an aggressive risk tolerance, Kaye's recommendations may seem cautious. But given that few retirees would be happy to run short of funds by their 80s, he said, "if you're going to make a mistake, make a mistake by being too conservative."

(Putting a portion of your money in an annuity is another way to guard against big fluctuations in stocks, although it's not an unqualified good. Money Magazine's Walter Updegrave explains why.)