Many people think of retirement as a time to relax and enjoy the fruits of their labor. However, retirement can also be a time of financial insecurity, especially if the markets experience a downturn. During the downturn, as a retiree you may have to withdraw money from your investment accounts when your investment portfolio experiences a period of losses, which can have a major impact on your retirement plans. Conversely, for someone who retires during a period when the market is doing well, they may experience the retirement they always dreamed about. Ultimately, the order in which you experience gains and losses in our portfolio will determine how much you have for retirement. Hypothetically, two retirees with the same amount of money who retire at the same age but at different times may experience very different financial situations. This is known as sequence of returns risk, and it can have a devastating impact on retirement savings.
What role does luck play in your retirement?
Due to sequence of returns risk, many people believe that retirement is a matter of luck. After all, there are so many factors beyond our control, such as the stock market and the economy. While luck may play a role in retirement, there are also many things that we can do to improve our chances of success.
Exhibit 1 – unlucky investor
Portfolio value: $1,000,000; $40,000 annual withdrawals increasing by 2% each year, and actual return from S&P 500 starting in 2000. Source
Exhibit 2 – Lucky investor
Portfolio value: $1,000,000: $40,000 annual withdrawals increasing by 2% each year, and actual returns from 2019 to 2000 (reverse order). Source
As you can see above, at age 84, the unlucky investor is left with $567,000, while the lucky investor has over $2 million at age 84. Both started at the same place, but the unlucky investor’s portfolio never recovered because of the negative periods that she experienced. Conversely, the lucky investor had enough for retirement and to leave a decent legacy.
Strategies to protect against Sequence of return risk
One of the biggest risks retirees face is the risk of a negative sequence of returns. This is when your investment portfolio experiences a period of losses that can have a major impact on your retirement plans. There are several ways to eliminate this risk, including
Dynamic spending rules: Dynamic spending rules are a type of retirement withdrawal strategy that adjusts the amount of money you take out each year based on how your portfolio is performing. The idea is to withdraw more money when your portfolio is doing well and less money when it’s not doing as well, in order to help preserve your capital. This can be a good way to protect yourself from the negative effects of the sequence of returns. By withdrawing your assets at a slower rate during these periods, you can help ensure that you don’t run out of money later on. Of course, dynamic spending rules are just one retirement withdrawal strategy and there are other factors to consider as well, such as inflation and your desired lifestyle in retirement. But if you’re looking for a way to help manage the risk of retirement, dynamic spending rules may be worth considering.
The 4% rule: The 4% rule is a retirement planning guideline that suggests that retirees can safely withdraw 4% of their nest egg each year, adjusted for inflation over a 30-year retirement. The rule is based on the premise that retirement portfolios are composed of a mix of stocks and bonds, and that over time, the stock market will provide returns that exceed inflation. While the 4% rule is by no means a perfect retirement planning tool, it can help to protect retirees from the negative effects of the sequence of return. For example, if a retiree experiences a series of poor investment returns early in retirement, the 4% rule would allow them to adjust their spending accordingly, rather than having to make drastic cuts to their lifestyle later on. In this way, the 4% rule can help to ensure that retirement nest eggs last as long as needed. While this rule has been used for many years, due to market conditions in recent times it has been suggested that the amount of the withdrawal should be lowered to 3.3%. Ultimately, once you have completed your plan with a financial advisor you will start to see what amount is most realistic based on your situation.
Diversifying your investments: By investing in a variety of asset classes, you can help protect yourself from losses in one area of the market.
Investing for income: Income-producing investments, such as bonds and annuities, can provide stability during periods of market volatility.
Building up cash reserves: Having a large cash reserve can help you weather short-term market fluctuations and prevent you from having to sell investments at a loss.
Bond Laddering: Bond laddering is a retirement planning strategy that involves investing in a sequence of bonds that mature at regular intervals. The intervals can be monthly, quarterly, or annually, depending on the investor’s needs. The main advantage of bond laddering is that it helps to mitigate the risk of retirement income fluctuation due to changes in market interest rates. By laddering bonds with different maturity dates, investors can earn a consistent stream of income while minimizing their exposure to market volatility. For example, if interest rates rise, the investor will still receive income from the bonds that have already matured. Conversely, if interest rates fall, the investor will benefit from having bonds with longer maturity dates. Overall, bond laddering can be an effective retirement planning tool for risk-averse investors.
Keep working: Working in retirement will mean that you continue to contribute to your investment portfolio and there is an opportunity for growth. When you retire, your retirement savings become your only source of income. This means that it’s essential to make your money last as long as possible. To protect against sequence of return risk, you may consider working part-time during retirement. By supplementing your retirement income with wages, you can reduce the impact of any negative investment returns. In addition, working during retirement can give you a sense of purpose and help to keep your mind sharp.
Home Equity: With a home equity line of credit, you can use your home equity to act as a buffer against this sequence risk. This may not be your first choice but it is an option. By taking out a home equity line of credit, you can have access to cash should you need it during a period of low or negative investment returns. This cash cushion can help to ensure that you don’t have to make any drastic changes to your retirement plan, and can help to keep you on track for a successful retirement.
Life Insurance: Life insurance can help protect against the sequence of return risk by providing a death benefit that can be used to cover expenses if the retiree dies during a period of low asset values. This can help ensure that the retiree’s beneficiaries do not experience financial hardship in the event of an untimely death. In addition, life insurance can also be used as a source of retirement income if the policyholder chooses to cash in or borrow against the policy. Thus, it provides a measure of financial security during retirement, even if stock prices are volatile.
There is no doubt that luck plays a part in retirement; it is second only to your withdrawal rate. However, the more you plan, the luckier you can become.
