Even if you’ve saved diligently and invested prudently, every investor knowingly takes on some risk that well-laid plans could shift, but it’s tough to feel truly prepared – emotionally, at least – to start drawing down a portfolio, especially if you anticipate entering into a down market.
This is what’s known as “sequence of returns risk” – the possibility that a down market near your retirement date could affect your future spending power. The timing is significant because you may not have the ability or time to make up sustained losses that occur just prior to retirement. It becomes even tougher if these portfolio losses occur after your retirement since you no longer have the option of replenishing your retirement assets by saving a portion of your wages.
The good news is that sequence of returns is a risk one can manage – if you implement a well-thought-out plan.
Investors who want to guard against sequence of returns risk have a number of options. What’s right for you will depend on your overall assets and their allocation, your specific risk tolerance, and other personal factors.
That said, here are several strategies that can serve as a starting point for the conversation:
Build a buffer
It’s possible to mitigate sequence of returns risk by determining how much you need in retirement to cover your basic living expenses, like mortgage payments, groceries, utilities, insurance, transportation and healthcare, then creating a portfolio to safely cover those expenses. This may include income sources, in addition to your Social Security, like pensions, fixed-income assets, bond ladders and in a few relevant cases, annuity payouts.
If those options don’t appeal to you, you can further protect yourself by holding a cash cushion equal to a decided number of months’ living expenses. Tap that cushion when markets underperform and build it back up when markets outperform.
Create flexibility
Retirees often assume they can withdraw a certain percentage of their total portfolio, increasing that amount every year to account for inflation. Under this formula, a $1 million portfolio and 4% withdrawal rate would provide pretax income of $40,000 in year one and – assuming inflation runs 2% annually – $40,800 in year two, $41,616 in year three and upward from there. This strategy typically works well as long as no significant unexpected events occur. In fact, historically speaking, this strategy has allowed people to enjoy steady income while still growing total assets.
However, because you set the rate at the beginning of retirement, it doesn’t factor in some of the “what ifs” that might come along. Should your wants and needs deviate from your planned expenses, or the market become unpredictable, your measured withdrawal plan may not keep up. In fact, your retirement portfolio may be shrinking just as the absolute amount you are withdrawing is rising.
One can avoid this by building in some flexibility. Retirees generally spend more in the early years and taper down as they accomplish their goals (such as traveling with family, a vacation cabin). Once you’ve identified your spending goals, revisit your withdrawal plan every three to five years to ensure it can keep pace. If it doesn’t, it may be best to establish a relatively conservative withdrawal amount and adjust with the market. If your portfolio experiences a market boost early on, adjustments can be made upward to allow for higher withdrawals.
Another option is to set a fixed percentage based on the year-end value of your portfolio. This could mean, however, that you’ll have flush years and leaner ones, depending on the market. Alternately, you can establish a “floor” – an amount that can be withdrawn in any market environment to cover your basic needs – and adjust discretionary spending according to your plan’s performance.
Lastly, consider how your income sources will perform in “normal” markets, recessions or periods of high inflation. For example, Social Security, which generally includes a cost of living increase each year, should hold steady in a variety of economic environments. Its resilience is a great reason for you and your spouse to maximize this income stream if you can.
Adjust as needed
The idea is to put your eggs in several baskets, since it’s impossible to know what the markets will do this year or next, much less over 20 to 30 years of retirement. Even with a carefully planned withdrawal strategy, you can’t account for everything. The key is to not overreact when something unexpected comes your way. Even small changes can have a big effect when compounded over the long term. When things do change, take the time to revisit your withdrawal strategy with an unemotional and trusted professional.
There is no assurance that any investment strategy will be successful. Investing involves risk including the possible loss of capital. Annuity guarantees are based on the claims paying ability of the insurer. The market value of fixed income securities may be affected by several risks including interest rate risk, default or credit risk, and liquidity risk. Asset allocation does not guarantee a profit nor protect against loss. Withdrawals may result in a reduction of your account’s principal. Sources: Raymond James Commentary & Insights
Securities offered through Raymond James Financial Services, Inc., member FINRA/SIPC.© 2021 Raymond James Financial Services, Inc., member FINRA/SIPC. Investment advisory services offered through Raymond James Financial Services Advisors, Inc. King Financial Partners is not a registered broker/dealer and is independent of Raymond James Financial Services.
Tom King CFP®, CLU®, AEP® is Registered Principal of King Financial Partners (222 Blue Course Dr., State College, PA). King Financial is a team of credentialed professionals specializing in retirement, investment management, wealth transfer, and estate planning. Tom can be reached at Tom@goKFP.com (814) 234-3300.
