Advisors blessed with intelligent clients rarely need to explain the importance of saving: clients know that funding their retirement is fundamentally their responsibility. But an excess of virtue can become a vice. 

The purpose of decades of saving is to fund decades of spending.  One of an adviser’s core challenges is to educate clients about swerving from aggressive accumulation, to designing their portfolio for measured decumulation.  This is captured in the title of my recent book co-authored with Riaan Nel: It’s the Income, Stupid!

This column introduces the profound paradigm shift clients will need to undertake, redesigning their portfolios to produce predictable income in the “new normal” of miniscule interest rates.  We hope you share it with your clients, so that they better understand your advice.

In Kathryn Forbes’ much-loved book, Mamas Bank Account (best remembered through the 1948 film I Remember Mama), each Saturday evening Papa Lars would bring home his carpenter’s pay in coins. Mama Marta would allocate the funds “to the landlord…to the grocer,” etc. It is a charming scene.

Most of us do something similar with our savings. We distribute our earnings into “envelopes,” or establish mental accounts, that devote pieces of our overall assets to different purposes. We may have, for instance, mental accounts for housing (rent or mortgage), transportation, food, gifts, and luxuries like a vacation. Many households aspire to have a “rainy day” fund for emergencies, although for many it is only a hope.

Each account may be invested differently. An emergency fund envelope should be in a highly liquid form because an illness or layoff may strike at any time. The goal of an emergency fund isn’t growth, but capital preservation and immediate access. The same is true for any envelope related to day-to-day spending. A near-term goal envelope may be targeted to a goal that is still a few months or years in the future. For example, a “goal fund” may be used for a house down payment, college tuition, a wedding, or an expensive vacation. A specific mid-term goal envelope, such as for a vacation or a house down payment, can be invested with some growth in mind. However, capital preservation is still important.

Finally, a really long-term goal envelope, like retirement savings, can be invested for growth, as long as the long-term goal is still far away. However, as the day approaches when the long-term goal envelope is needed—when that long-term goal becomes a mid-range goal, and then a short-range goal—the investment strategy should change accordingly.

A common but outdated rule for really long-term goal funds is that a growing percentage of the portfolio should be in bonds (which are less volatile than stocks, but also return less). That percentage should be roughly equal to the investor’s age. Under this guideline, a 58-year old investor saving for retirement should have roughly 58% of his or her retirement savings in bonds.

As we’ve alluded to in previous chapters this is an outdated approach, as much of the research on reverse glide paths illustrates: It’s better to glide toward a conservative allocation the closer to retirement you get, and then reversing the process to glide to increasing stock allocation the older you get.

The mental accounts or “envelopes” method is natural for most people. Establishing those accounts literally—that is, investing a portfolio into different components for different time horizons—has also been proven to stretch retirement dollars farther. This approach was the financial advisor Harold Evensky, and later popularized by some financial planners as well as by Christine Benz, the director for personal finance at Morningstar.

An Envelope Framework

The linchpin of the approach is to establish a dedicated safe liquidity pool to provide for your income needs the first few years of retirement. The precise number of envelopes or buckets you need will depend upon the breadth of your financial goals. For retirement planning, the minimum you should consider is two: a long-term growth envelope, and a safe liquid spending envelope with two to three years’ worth of cash to meet your spending needs. We will argue that it is better to use at least three envelopes when constructing a retirement portfolio. For shorter term pre-retirement goals, you can expand this approach and proliferate envelopes—at the cost of increased complexity and hassle.

Here is an example of how you could structure an envelope scheme for retirement:

Emergency expenses (Envelope 0): Establish an emergency fund to cover unforeseen contingency expenses. This envelope is separate from the other three envelopes, which are designed to meet your income needs through your retirement. It will be superseded by Envelope 1 once you retire. This envelope consists of cash.

Regular spending (Envelope 1): Throughout your retirement your regular spending will come from Envelope 1. When Envelope 1 is depleted it is refilled with ultraconservative and safe investments. It should include enough cash for approximately two years of normal expenses. Cash or cash equivalents are the core of Envelope 1. Capital preservation is key for investments held in this envelope. Envelope 1 is the source from which regular spending occurs for around five years. (Evensky’s original bucket design was 5/5/5—the number of years each bucket covers.)

Medium-term spending (Envelope 2): This envelope contains assets you plan to use in the mid-term (the next five to 10 years), invested for stability rather than growth. That is, you take only moderate risk with this envelope. As you approach the fifth year (the end of the investment time horizon for Envelope 1) you will need to start liquidating assets in Envelope 2 to create a new envelope 1.

Growth and inflation hedging (Envelope 3): You have to create a long-term growth envelope. In this envelope you hold assets you don’t expect to touch for at least 10 to 15 years. These will be invested for growth and serve as your main hedge against inflation.

Each envelope can use different types of assets. The general idea is that Envelope 0 and most of Envelope 1 should be in very liquid form, such as savings and money market accounts. Envelope 2 should be in short to intermediate duration bond funds. You could include some high quality, income-focused stock investments for a small part of Envelope 2. Envelope 3 should be in illiquid alternatives and stocks (including stock funds and ETFs).

The idea is that you will spend the contents of Envelope 1 for each year that you have planned it (say, five years). At the end of the five-year period you will refill Envelope 1 from Envelope 2. As you approach year 10 (when the assets in Envelope 2 will be depleted), you will refill Envelope 2 by liquidating riskier assets like stock mutual funds in Envelope 3 to reinvest in more moderate assets like bond mutual funds in Envelope 2.