By Jon L. Ten Haagen, CFP ®
In an ideal world, your retirement would be timed perfectly. You would be ready to leave the workforce, your debt would be paid off. And your nest egg would be large enough to provide a comfortable retirement – with some left over to leave a legacy for your heirs.
Unfortunately, this is not a perfect world, and events can take you by surprise. In a survey conducted by the Employee Benefit Research Institute, only 44 percent of current retirees said they retired when they had planned; 46 percent retired earlier, many for reasons beyond their control. But, even if you retire on schedule and have other pieces of the retirement puzzle in place, you cannot predict the stock market. What if you retire during a market downturn, such as those in 2001 or 2008?
Sequencing risk – The risk of experiencing poor investment performance at the wrong time is called sequencing risk or sequence of risk returns. All investments are subject to market fluctuation, risk, and loss of principle – and you can expect the market to rise and fall throughout your retirement, as they have during your accumulation phase. However, market losses on the front end of your retirement could have an outsize effect on the income you might receive from your portfolio.
If the market drops sharply before your planned retirement date, you may have to decide between retiring with a smaller portfolio or working longer to build your assets. If a big drop comes early in retirement, you may have to sell investments during the downswing, depleting assets more quickly than if you had waited and reduced your portfolio’s potential to benefit when the market turns upward. It is important that your CFP talks with you years earlier about an emergency fund – one with low volatility you can tap into during market declines and not touch the equity positions.
Dividing your portfolio. One strategy that may help address sequencing risk is to allocate your portfolio into three different buckets that reflect the needs, risk level, and growth potential of the three retirement phases.
Short term (first two to three years): Assets such as cash and cash alternatives that you could draw on regardless of market conditions. Emergency funds.
Mid-term (three to 10 years in the future): Mostly fixed income securities that may have moderate growth potential with a low or moderate volatility. You might also have some equities in this bucket.
Long-term (more than 10 years in the future): Primarily growth oriented investments such as stocks that might be more volatile but have higher growth potential over the long term.
Throughout your retirement, you can periodically move assets from the long-term bucket to the other buckets so you continue to have funds in all three buckets. This enables you to take a more strategic approach in choosing appropriate times to buy and sell assets. Although you will always need assets in the short term bucket, you can monitor performance in your mid-term and long-term buckets and shift assets based on changing circumstances and long-term market cycles.
If this strategy appeals to you, consider restructuring your portfolio before you retire so you can choose appropriate times to adjust your investments.
Determining withdrawals: The three-part allocation strategy may help mitigate the effects of a down market by spreading risk over a longer time period of time, but it does not help determine how much to withdraw from your savings each year. The amount you withdraw will directly affect how long your savings might last under any market conditions, but it is especially critical in volatile markets.
One common rule of thumb is the so-called 4 percent rule. According to this strategy, you initially withdraw 4 percent of your portfolio, increasing the amount annually to account for inflation. Some experts consider this approach to be too aggressive – you might withdraw less depending on your personal situation and market performance, or more if you receive large market gains. These estimates were put out years ago when interest rates were higher. Talk with your CFP to see if these numbers work for your situation.
Another strategy, sometimes called the endowment method, automatically adjusts for market performance. Like the 4 percent rule, the endowment method begins with an initial withdrawal of a fixed percentage, typically 3 percent to 5 percent. In subsequent years, the same fixed percentage is applied to the remaining assets, so the actual withdrawal amount may go up or down depending on previous withdrawals and market performance.
A modified endowment method applies a ceiling and or floor to the change in your withdrawal amount. You still base your withdrawals on a fixed percentage of remaining assets, but you limit any increase of decrease from the prior year’s withdrawal amount. This could help prevent you from withdrawing too much after a good year, while maintaining a relatively steady income after a down market year.
Note: Asset allocation is a method used to help manage investment risk; it does not guarantee a profit or protect against investment loss. As always I suggest you discuss these important decisions with a qualified Certified Financial Planner. Have a great fun summer and call us with your questions and comments