Explore strategies for protecting your future spending power.
Even if you’ve saved diligently and invested prudently, it’s possible that the twists and turns of 2020 left you feeling less than confident in the retirement you’ve planned for. Sure, 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 in a down market.
This is what’s known as “sequence of returns” or SOR 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 SOR is a risk you can manage – with a well-thought-out plan.
Investors who want to guard against SOR risk have a number of options. What’s right for you will depend on your overall wealth, your asset allocation, your specific risk tolerance and other personal factors best discussed with your advisor.
That said, here are several strategies that can serve as a starting point for the conversation.
It’s possible to mitigate SOR risk by determining how much you need in retirement to cover essentials, like mortgage payments, groceries, utilities, insurance, transportation and healthcare, then creating a portfolio of guaranteed income. You’re looking for sources like pensions, Social Security, fixed-income assets/bond ladders and annuity payouts. If your daily expenses are covered by a steady stream of income, you can weather zigzagging markets by simply skipping that next vacation or delaying the purchase of that new car. As an alternative, you could consider downsizing or taking on contract work.
If those options don’t appeal to you, you can further protect yourself by holding a cash cushion equal to six to 12 months of living expenses. Tap that cushion when markets underperform and build it back up when markets outperform.
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 3% annually – $41,200 in year two, $42,436 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 budget 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.
You can avoid this by building in some flexibility. Retirees generally spend more in the early years and taper down as they accomplish their goals (e.g., 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. Your advisor can help you analyze each one so you understand their ability to withstand a long haul. 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, so work with your advisor to determine when and how to start claiming benefits.
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 a voice of reason, like a trusted advisor. During periods of rocky market performance, you’ll be better prepared to cut discretionary spending or tap into existing lines of credit to improve the long-term sustainability of your retirement income.
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.