Editor’s note: This is part three of a three-part series that takes a look at planning for retirement during the “fragile decade” — the five years before you retire plus the first five years of your retirement. Part one is In Retirement Planning, Consider the Entire Journey. Part two is Goals-Based Retirement Planning Is All About You.
When it comes to withdrawing from your portfolio, many retirees fear that their cash flow might run out before they do. As illustrated in part one of this series, relying on stock sales to meet retirement expenses can be risky, especially during a market downturn early in retirement.
How can we leverage the insights from parts one and two to safeguard our retirement income? Here are four actionable steps to consider.
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Redefine and reframe your principal risk
Price volatility is a popular measure of risk but not a great one for retirement planning. Volatility on its own is simply a probability statistic (and hence why it’s described with technical terms such as alpha, beta, R-squared and the Sharpe ratio).
For our financial planning purposes, volatility needs to be linked with a consequence to provide a practical measure of risk. For example, the fundamental risk in your portfolio is not having the cash available when you need it to meet your spending needs. In measuring your success, your personal monthly spending need is your ultimate yardstick and the only benchmark that matters.
If an adviser says to you (or you tell yourself) that you beat the market last year, your response should be, “Interesting information, but not my primary focus. Much more important, where am I relative to my financial goals, and do I need to course-correct?”
Utilize a goals-based safety-first strategy
With a more practical and fundamental definition of risk, it’s time to let your financial goals guide your planning and investing, not simply your risk tolerance. Match your assets and income with future liabilities and spending.
The premise of our goals-based safety-first strategy is to rely as little as possible on the sale of stocks to cover basic needs, especially when the stock market is falling. Your primary objective during the withdrawal stage is not to maximize investment returns, but rather to meet your spending needs.
Add a margin of safety to your projections
Lower your projected withdrawal rate in your modeling to account for the sequence of returns risk (that is, the risk that you start withdrawing during a bad stretch of market returns). Financial author William Bernstein calculated that a particularly bad sequence of returns can penalize your safe withdrawal amount by about 1.5 to 2 percentage points.
So, for example, if you are projecting a 5% withdrawal rate, consider lowering that estimate to an amount closer to 3% to 3.5% to provide cushion against “bad” market returns in the early years of the withdrawal stage. This may also lead you to conclude that you need to make other course corrections — for example, targeting a larger portfolio balance on your retirement date than you originally assumed. Simply put, plan to spend less and save more.
Maintain a cash reserve
As you approach your retirement date, have a cash cushion. Keep three to five years of spending needs out of the stock market and in cash. Since you hopefully won’t need to sell and withdraw from the equity portion of the portfolio if the market is declining, you avoid the negative compounding effects we saw illustrated in part one. (Remember, compounding works with you during the accumulation stage and against you in the withdrawal stage.) And as the market eventually recovers, you can then sell some of your equity investments to replenish your cash reserve.
Three to five years of cash is my personal comfort zone. What do others say? Author and investor Darrow Kirkpatrick found that the S&P 500 recovers from declines, on average, in about three years. For business cycle declines going back to the 1800s, it’s about five years. Citing research by Wade Pfau, Kirkpatrick notes that worst-case real stock market losses of greater than 50% take, on average, nine years to recover.
Based on Kirkpatrick’s findings, on a worst-case basis, you might consider having upwards of 10 years of spending needs in cash, plus potentially more in other conservative investments.
Take as little risk as you need
The above suggestions are but four considerations as you make personal course corrections to your robust financial plan. My primary message is this: Make sure to reconcile cash withdrawal plans with what your modeling and current market conditions indicate you can support.
In other words, as you plan for the withdrawal stage, don’t take as much risk as you can tolerate; take as little risk as you need.
With a focus on safety first to cover basic spending needs and the right balance of liquidity, the fragile decade can be a lot less frail.
As always, invest often and wisely. Thank you for reading.
This content is for informational purposes only. It is not intended to be, nor should it be construed as, legal, tax, investment, financial or other advice.
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