The Biggest Danger to Your Retirement: Sequence of Returns

During the accumulation phase of your retirement portfolio, you probably think the biggest danger to your retirement is not saving enough — or not seeing a high enough annualized return.

What you might not realize, however, is that the biggest danger to your retirement occurs after you’ve retired. The sequence of returns you see from your portfolio, and the way you withdraw your money after you’re done working full-time can have a huge impact on whether or not you outlast your money. 

Stock Market Losses and Your Early Retirement

One of the mantras we hear is that you can ride out most market events if you wait long enough. In general, this is true — especially if you are younger and in the accumulation phase of your retirement portfolio.

The problem comes in when you are older, have a much larger portfolio (a 20% market drop impacts a $1 million portfolio more than it impacts a $100,000 portfolio), and a market drop occurs close to the beginning of your retirement.

When you’re in retirement mode, you’re withdrawing money from your account, and that means “locking in” some of your losses. If you have a $1 million retirement portfolio, and the market drops 20%, your portfolio is suddenly worth $800,000 if it’s all in stocks.

If you aren’t retired, you might have time to ride it out. In retirement, though, you are withdrawing money to live on. As a result, you are drawing down your portfolio at a faster rate, selling shares that are worth less (and, consequently, you have to sell more shares to get the same results as before). Once the market starts gaining again, you don’t see the same level of recovery in your portfolio because you have fewer shares.

A big stock market drop early in your retirement can make a huge difference in how long your retirement lasts, especially if you are using a method of withdrawal that involves a set dollar amount, instead of a percentage of assets.

Combating Risk from Sequence of Returns

There are some strategies you can employ to help you reduce the risk associated with your sequence of returns. Talk to a financial planner or retirement planning expert about your options, and what might work best for you. Here are some of the strategies you can employ to reduce the risk that comes with a market drop while you are in retirement and need to withdraw the money:

Adjust your asset allocation

As you approach retirement, begin shifting more of your assets into high-quality bonds. Sell your stocks and consider buying Treasuries or other bonds. Many retirees can protect their assets to some degree by allocating more of the portfolio to TIPS, which are inflation protected Treasuries. These types of fixed-income assets can help protect you when the stock market drops.

Consider an annuity

Annuities aren’t for everyone. However, in some cases an immediate annuity that is simple and straightforward can make sense. While you might not want to put everything into an annuity, you can figure out how much monthly income you need to cover basic expenses. Get an annuity with a payout that will cover those expenses with a portion of your portfolio and then manage the rest for return. If you need to cut back on what you withdraw from the rest of your portfolio, at least you know the basics are covered with the annuity payout.

Withdraw assets based on a percentage rather than a fixed-dollar amount

You might decide that you need $3,500 a month to live your preferred lifestyle. Unfortunately, with a fixed-dollar amount, you could end up drawing down your portfolio at a faster rate during market drops, even if you have adjusted your asset allocation. Instead, choose a withdrawal rate that makes sense for your situation. Many people like a 4% withdrawal rate. You can withdraw 4% of your assets each year, and that can reduce the chances of running out of money because of down markets. The downside to the percentage is that in years when your portfolio has lost value, you might have to tighten your belt more because 4% of $600,000 is a lot less than 4% of $800,000.

Carefully think of your situation and consider how you will handle sequence of returns. Start thinking about this five to 10 years ahead of your retirement so you can begin making appropriate adjustments to your overall retirement strategy.

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investing for retirement ebook ipad - McClain Lovejoy
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