Timing is everything. That old adage holds particularly true when it comes to how your investments perform as you retire. Get a string of good returns in the years leading up to and just after you retire, and your portfolio could provide more than you ever hoped. But if those years fall in a down market, your portfolio may run out of steam before you do.
Because you’re dollar-cost averaging over many years while saving for retirement, the timing of market ups and downs is not critical during the accumulation phase. But, says Sri Reddy, senior vice president and head of full service investments at Prudential Financial, the sequence of returns “affects investors much more in the withdrawal stage.”
Greg Ghodsi, managing director of investments for financial services firm Raymond James, offers this simple example: Let’s say you retire with a $1 million portfolio and plan to take out 5% in the first year, or $50,000. But in the months before your first withdrawal, markets drop 25%. If you still take out $50,000, it will be a larger percentage of your nest egg than you expected, because now your portfolio is only worth $750,000. What your carefully laid-out plans expected to be a 5% distribution claims nearly 7% of your shrunken portfolio. “That can eat into principal significantly,” says Ghodsi. If negative returns continue over several years of retirement and you don’t adjust withdrawals, the damage to your nest egg will accelerate.
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After years of the stock market climbing to new highs, it may be hard to fathom a sea of red ink on your investment statements. But those who retired a decade ago at the dawn of the Great Recession could tell you a tale or two about the pain of seeing a nest egg cut in half, throwing off well-thought-out retirement plans.
Hopefully that won’t happen again soon, but it’s a good idea to have a detailed plan about how to handle volatility as you retire. You can’t stop markets from swinging, but you can take steps to mitigate the pain of a lengthy down market early in your retirement years.
Preretirement
In the home stretch, keep saving. But three to five years away is also a great time to practice retirement. Forecast your first few years of spending as a retiree, and test it out. Is the budgeted amount enough? Or are you exceeding your expected spending?
You can develop an investment strategy to help fend off a bad sequence of returns. Create a bucket of cash for one year of expenses and a second bucket of short-term fixed-income investments that you can tap for three to five years’ worth of expenses. That allows you to keep the rest of your portfolio in riskier assets that can continue to grow—or recover from a blow.
The cash bucket is key to helping your portfolio survive a downturn: If you experience a bad-performing year in the first few years of retirement, you’ve got cash handy to meet current expenses without having to tap stocks or other assets at depressed prices. Your near-term bucket is designed to fill in the gap between spending needs and income from Social Security, a pension or a part-time job, says Scott Thoma, retirement strategist at investment firm Edward Jones.
Ensure your portfolio is well diversified, with investments in different asset classes and sectors. The less the assets move in lock step, the safer your portfolio will be. Ghodsi recalls a new client whose portfolio was worth $5 million before the Great Recession. But it was mostly in bank stocks, which went down 90%, leaving the client with just $750,000. Spreading your money around is essential to avoid such a nightmare.
Have a financial adviser model what will happen to your portfolio and income in good years and in bad years. “It’s a really good exercise to look at what would happen if markets tumble after you retire,” says Kate Stalter, co-owner of Better Money Decisions, a financial-planning firm. Tweak your plans if the results look bad. Maybe you need to stash away more, delay your retirement date, or buy an annuity to ensure essential expenses are covered when you are no longer working.
Early Retirement
Sequence of returns risk doesn’t go away on your retirement date. The early years are “a very precarious point in one’s retirement,” says Stalter. You no longer have a paycheck, you have decades of retirement ahead to pay for, and filling up your free time may be more costly than you thought. Add in a down market, and you could have the perfect recipe for a heap of trouble.
A well-diversified portfolio will help ride waves of volatility, as will a cash stash to meet several years of basic expenses. If you laid a foundation of guaranteed income, that bedrock will help cover the essentials.
If markets suddenly drop, focus on cutting discretionary spending. Sell depreciated assets to meet expenses, and you lock in the loss and forfeit the chance to benefit from any rebound.
Mitigate that double whammy by using a “dynamic spending” strategy that adjusts to market conditions. The old rule of thumb was to take 4% a year, with inflation adjustments. But do that when assets are down and you risk depleting your nest egg early. Instead, in a down market, forgo the inflation adjustment that year, or decrease the percentage you withdraw. If your $1 million nest egg falls to $900,000, for example, drop your original $40,000 withdrawal to $36,000.
Thoma suggests two ways to reduce reliance on portfolio performance: Delay Social Security to boost your benefit, and consider annuities for guaranteed lifetime income. That income can help cover essential expenses, so your portfolio only covers spending you can rein in. The more you rely on portfolio performance to cover basic costs, the more at risk you are if you’re handed a bad sequence of returns.
Mid to Late Retirement
There’s a silver lining if a down market appears well into retirement: There are fewer years left to rely on your nest egg. Still, be careful with withdrawals. Some expenses, such as travel, may go down, but other expenses, such as health care, likely will go up.
Investing in a qualified longevity annuity contract is one way to protect these later years. Buy one in your sixties, with payouts starting around age 85. The long wait means a relatively small investment early can produce a healthy payout late in life, reducing the amount of time your portfolio has to last.
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