Almost anyone newly retired must feel like they have the worst timing in the world. A portfolio tends to be larger closer to retirement, just before those savings are about to be used. These days, however, most wallets have lost value; the S&P 500 is down about 20% since the start of the year.
The financial industry has a name for this scenario: return risk sequence. “What matters most in retirement is selling assets for income,” says Wade Pfau, professor of retirement income at the American College of Financial Services in King of Prussia, Pennsylvania. “You have to sell more stocks to get the same amount of money. Those stocks then disappeared, so even if the market bounces back, your portfolio won’t recover as much.
New retirees are particularly vulnerable because they “rely on this money to fund the next 20 to 30 years of their lives,” says Amit Sinha, head of multi-asset design at Voya Investment Management in New York.
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Sequence of return risk is less of a concern for someone further into retirement, as retirees generally opt for safer and more conservative investments and have fewer years to pay. Additionally, these investors may have benefited from portfolios boosted by strong returns in early retirement.
Likewise, if retirement is a decade or more away, what happens to the markets today is virtually irrelevant. “You just let the composition work for you and recover over those years,” Sinha explains.
Someone retiring now, of course, doesn’t have that luxury. If this describes you, there are several things you can do to minimize the damage, but first assess what it’s likely to mean for your wallet in the long run.
Depending on how you react now, the damage may not be as severe or as long-lasting as you think.
How bad is it?
Sinha ran a sequence of return risk simulations for every year dating back to 1977, including some of the worst years in recent memory when S&P 500 losses were even greater than today: the financial crisis that began in 2007 (-51.93%), the dot-com crash (-36.77%) in 2000, and Black Monday in 1987 (-33.51%).
The key message investors should take away from his research? Don’t switch to an all-cash wallet. He compared what those savings would look like if the investor started their retirement all in cash and stayed that way instead of maintaining a 40/60 portfolio of stocks and bonds. “Even for the worst sequence risk scenarios, the stock and bond portfolio would outperform by staying in cash. In some cases, the early years were quite painful, but ultimately investment portfolios are always come out on top,” says Sinha.
For example, someone who retired just as the dotcom bubble burst would have had about 10-20% less savings than the cash portfolio for the first five years of retirement. At that point, both approaches broke even for some time. Then, after 10 years, the investment portfolio began to slip away and by the 20th year of retirement was worth twice as much as the all-cash portfolio.
Sinha also calculated how long these savings would last after a large loss in the first year of retirement, assuming an initial withdrawal rate of 4% and a long-term annualized return of 5%.
“If your portfolio lost 25% of its value in the first year, it should last another 40 years safely. Even if your portfolio has lost 50%, it should last 18 years,” he says, adding that the odds of a 50% year-over-year decline are low for a balanced portfolio of stocks and bonds.
Markets will eventually recover, and with them a balanced portfolio will too. The average bear market lasts 289 days, according to investment website Seeking Alpha, and some rallies happen quickly.
“The pandemic was a perfect example. Those who cashed in missed the sudden bounce,” says Pfau. In fact, Pfau suggests remembering how strong returns have been in 2021. “Markets did exceptionally well last year,” he says. “With this year’s decline, average returns are more in line with the 5-10% annual we expect, compared to last year’s gain of more than 25%. When you think about it this way, your portfolio’s performance might not be that far behind. »
make your own luck
If cashing out now is the worst thing you can do, what are some smart steps to take instead? Here are several strategies to minimize the damage caused by the return risk streak and make your savings last.
Reduce your withdrawal rate. Financial theory predicts that you can withdraw 4% from your initial retirement portfolio and continue to withdraw that same amount each year without running out of money for 30 years, even after incurring an initial loss. Someone who started withdrawing $40,000 a year from a million dollar portfolio just before the bear market started could theoretically continue to do so now.
But if you want to play it safe, you can reduce the amount you withdraw. For example, if your portfolio is now $800,000, you could only withdraw $32,000 per year, or 4% of your remaining balance. Pfau suggests using a variable withdrawal strategy, withdrawing more from good investment years and less from bad ones. “When the market is down, you might have the attitude that I’ll spend less to ease the pressure on my wallet.” Of course, living on much less income may not be possible, but anything you can do to reduce your withdrawals leaves more of your portfolio untouched for an eventual rebound.
Tap on non-market assets. Pfau also suggests looking at your other assets, like borrowing the cash value of a life insurance policy or using a reverse mortgage to tap into the equity in your home, as alternative sources of income while the market is down. falling. When the market recovers, he says it’s up to you whether you want to repay those loans, depending on how much you want to leave to heirs.
Further diversify your portfolio. Greater investment diversification could accelerate how quickly your portfolio recovers. “If your stocks are all US companies, maybe add international investments,” Sinha says. “That way you’re not just relying on one bet: the recovery of the US economy.”
Consider an annuity. To help offset market volatility, you can transfer part of your portfolio to an annuity, which turns your payout into future income. Some annuities offer lifetime guaranteed payments that do not change with market returns. “Creating a revenue stream that isn’t dependent on the market can help reduce the return risk streak,” says Dave Kloster, president of investment management at Thrivent in Minneapolis.
Pfau acknowledges that it might be harder to fund an annuity now if your wallet takes a hit. He says this strategy is worth considering if you still have the money to buy an annuity, or if you can wait for the next market bounce.
Invest cautiously at first. This next strategy won’t help a new retiree now, but it’s something to remember if you plan to retire at a later date after the market recovers. Since portfolios are most vulnerable to sequence risk in the early years of retirement, Pfau suggests investing much more cautiously at this stage: “Instead of the typical combination of stocks and bonds 60 /40, consider starting with 30/70.” He says you should gradually increase the equity percentage to 60/40 during the first decade of retirement. “This strategy aims to avoid the worst-case scenario of a big loss when your portfolio is most important.”
Delay retirement. If you are not yet retired and can continue to work, you can wait for your portfolio to recover. You would avoid spending your savings at a low point and could invest some of your earnings now at bargain prices. Review your plan. In times of stress, it’s worth having a financial expert assess your retirement plan. “A well-designed plan should be able to handle market volatility,” says Kloster.
The discussion might make you feel more comfortable with the numbers and how your plan should hold up over time. “This will not be the only contraction period of our lives,” he says. “You need to be confident in your strategy to avoid making major changes based on market conditions, like selling low and buying high,” he says. “Find an acceptable level of risk and remember that it is impossible to time the markets.”
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