Week 33 - Rainy Day Fund in Retirement

Situation: It’s expected that retirement savings will be gradually depleted in retirement. But how do you deal with the unforeseen and unexpected expenditures that can upset an ongoing financial plan and derail your retirement savings?

This situation requires a backup plan--we need a “Super Hero” to step in and help. In an earlier blog (Week 15), we explained the importance of having a Rainy Day Fund and described the type of investments we would use to create such a fund. We can’t emphasize enough the importance of keeping contributions to the Rainy Day Fund on track throughout our prime working years; our 30s, 40s, 50s and right up into retirement.

The Rainy Day Fund that we suggest you establish is equally divided between Lifeboat Stocks and inflation-protected Savings Bonds, or “ISBs” (see Week 15). What this will achieve is that, by 10 yrs into your retirement, at least 50% of your stock holdings will be in Lifeboat Stocks (Weeks 8 & Week 23) instead of the 33% called for in our Goldilocks Allocation retirement savings portfolio (Week 3). This is important because Lifeboat Stocks are also termed “defensive”, meaning they don’t collapse in value during a bear market. Think about it. Having a bear market hit you two years into retirement might mean you’ll have to return to the workforce whether you like it or not.

Looking at the 2012 Master List (Week 27), we find 13 stocks representing “defensive” industries (health care, consumer staples, communication, employment services, utilities):

             ABT, KO, JNJ, MDT, PEP, PG, WAG

             WMT, ADP, BDX, HRL, MKC, and NEE.

And this is good because we can use these 13 stocks as candidates for our Lifeboat Stock designation (as defined in Week 25). Presently 12 of these 13 companies are relatively free of concerns. [The exception is ADP which has been bid up to a price (P/E=20) not justified by its low return on assets (ROA=3.6).] Seven of the remaining 12 are “Buffett Buys” from Week 30 (HRL, JNJ, MDT, WAG, BDX, WMT, NEE) but the remaining 5 also warrant Lifeboat Stock designation (ABT, KO, PEP, PG, MKC).

If used as 10+ yr DRIP investments with regular purchases in fixed amounts, any of these 12 stocks will more likely than not have a total return beating an S&P 500 Index fund AND show less depreciation during a bear market.

Since 7/1/02, for example, only MDT and WAG failed to do as well or better (in terms of regular DRIP investments) than the Vanguard S&P 500 Index Fund (VFINX); PG and JNJ DRIPs returned the same as VFINX (4.6%/yr). That’s 8 wins, 2 losses and 2 ties. With respect to price depreciation during the credit crunch from 10/07 to 4/09, all 12 of these stocks held up better than VFINX, which fell 47.6% vs. 21.6% for the 12 Lifeboat Stocks. Wow. Those ranged from an 18.8% gain (WMT) to a 48.9% loss (MDT).

To give you a concrete idea of what you accomplish by investing in Lifeboat Stocks to create a Rainy Day Fund, I will use my own Rainy Day Fund as an example. I created my fund on 7/1/02 using a quarterly investment of $630. I split this into $300/qtr for ISBs and $330/qtr for Coca-Cola (KO) in a dividend re-investment plan. As of 1/31/12, the $11,700 that I spent buying ISBs had grown to $14,278.34 (3.9%/yr) and the $12,928.55 that I spent on KO had grown to $18,476.95 (6.7%/yr). The result is that my Rainy Day Fund returned 5.4%/yr. For the sake of comparison, if we use a virtual $11,700 investment made in VFINX (Vanguard’s S&P 500 Index Fund) over this same period of time, it would have grown to be $14,847.98 (4.64%/yr). Inflation (Consumer Price Index) grew at a rate of 2.3%/yr. Therefore, my Rainy Day Fund had an after-inflation return of 3.1%/yr. This is a typical after-inflation return for a generic 50:50 stock:bond investment since 1970--after pricing in the tax benefits from owning Savings Bonds (Week 15).

Bottom Line: Every retiree would be smart to not only have a Rainy Day Fund going into retirement but continue adding the usual amounts after retiring. This could be the only unencumbered asset remaining in her portfolio to meet unexpected emergencies. It’s a real Super Hero that can step in and save the day!

Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com