In the financial planning world, the concept of “sequence of returns risk” plays an important role in retirement planning. This risk refers to how a portfolio performs during the first year in and around retirement. The larger the drop in a portfolio, the greater the risk the investor may have in depleting their retirement portfolio. Charles Schwab has put together some illustrations showing the impact on retirees who suffer a 15% hit to their portfolio early on.
Source: Schwab Center for Financial Research.
The example is hypothetical and provided for illustrative purposes only. It is not intended to represent a specific investment product. Dividends and interest are assumed to have been reinvested, and the example does not reflect the effects of taxes or fees. Both hypothetical investors had a starting balance of $1 million, took an initial withdrawal of $50,000, and increased withdrawals 2% annually to account for inflation. Investor 1’s portfolio assumes a negative 15% return for the first two years and a 6% return for years 3 – 18. Investor 2’s portfolio assumes a 6% return for the first nine years, a negative 15% return for years 10 and 11, and a 6% return for years 12 – 18.
Source: Schwab Center for Financial Research.
The example is hypothetical and provided for illustrative purposes only. It is not intended to represent a specific investment product. Dividends and interest are assumed to have been reinvested, and the example does not reflect the effects of taxes or fees. Both portfolios start with $1,000,000. Both portfolios experience 15% declines in years one and two, while both hypothetical investors also withdraw $50,000 per year. Starting in year three, both portfolios grow 6% per year. Investor 1 withdraws 2% per year. Investor 2 withdraws 4% per year.
Stock market volatility is normal and to be expected throughout a person’s retirement. After all, if there were no risks in investing, there would be minimal long-term reward. Considering the volatility found in stocks, how can a retiree potentially help protect themselves from the risks of the stock market and potentially bad timing? Let’s look at some tools we have in the toolkit:
Having a Financial Plan
Cash flow is a key part of your financial plan in retirement and understanding how much you will need and where your regular monthly income is coming from is important. Forms of income like Social Security and pension income can be helpful to weather times of uncertainty in the market. It’s helpful to understand how much money you can withdraw from your savings without significantly reducing your principal balance. A common guideline, often called the 4% rule, suggests that if an investor has a $1,000,000 nest egg, the investor could withdraw about $40,000 every year without significantly reducing their principal. However, this guideline has been questioned recently because retirees are living longer, which means savings need to last longer. To plan for this, we stretch our client’s life expectancy to 100 when making projections, which helps account for the possibility of longer retirement and may reduce the risk of running out of money.
Asset allocation matters
Holding a diversified portfolio of investments including stocks, bonds, real estate, cash and alternatives may help to reduce an investor’s risk. Bonds offer a more stable source of income and may provide balance during periods of stock market decline. If bonds increase in value when stocks decline, this may allow investors to sell bonds for needed income. While every situation is different, being fully invested in stocks at the start of retirement can expose a portfolio to greater short-term volatility, which may impact the sustainability of withdrawals. As always, asset allocation decisions should be based on your specific time horizon, income needs, and risk tolerance. Keep in mind bonds carry different types of risk. An investor needs to understand reinvestment risk, credit risk and duration risk (how interest rate sensitive a bond is). High quality investment grade bonds are where we focus to help mitigate some of this risk, mainly on the credit risk side. Credit risk is the risk associated with a bond issuer paying the investor their principal back at maturity. The higher a bond (the issuer) is rated on their credit (lower credit risk), the more likely the issuer will pay the investor back. High yield bonds (junk bonds) look enticing for the added interest that they pay, but these investments tend to have stock market-like risks. This is because these bonds tend to have high credit risk (lower credit ratings), meaning the issue may not pay the investor back at the maturity of the bond.
2022 was one of the worst years for bonds in recent memory (due to interest rates rising, also known as duration risk). The chart below highlights why the types of bonds that are owned by investors matter. Shorter term bonds performed better in 2022. This can be seen in the chart below. Short term US Treasuries lost value in 2022 to the tune of about 5%. Longer dated US Treasuries, specifically 20+ year US Treasuries lost over 30% of their value.
What about the Great Financial Crisis (2008 recession)? Bonds showed resilience in the face of a challenging stock market.
A portfolio with more bonds tends to grow more slowly over time and typically experiences smaller ups and downs in value during challenging market conditions. On the other hand, portfolios with more stocks may see greater long-term growth, however, they are likely to have larger fluctuations in value during market changes. Many investors have multiple account types (IRAs, brokerage accounts, Roth IRAs) and depending on age, cash needs and gifting goals, certain accounts may have more or less stock.
A technique to help maintain the correct mix of stocks and bonds is to rebalance the account regularly. What is rebalancing? This is the process of making sure your risk stays consistent through different time periods. Risk refers to your exposure or allocation to stocks versus bonds. For example, an investor with a moderate tolerance for risk may have 60% of their investments allocated to stocks and the other 40% allocated to bonds and cash. If stocks have a couple years of strong returns, that investor’s account may have an allocation to 70% stocks and 30% bonds and cash. It may be wise for the investor to then sell some of the stock and move the proceeds back into bonds and cash to ensure they are maintaining their risk tolerance.
Emergency Fund
Having an emergency fund is something that investors could consider. A common industry guideline is to maintain three to six months’ worth of essential living expenses in a liquid vehicle such as cash, money market funds, or short-term CDs. These options are generally not subject to market fluctuations, which can help provide stability in the event of unexpected expenses. While each client’s situation is unique, this guideline can serve as a helpful starting point.
Spend Less, Work Longer
There are a couple of additional strategies worth covering, although for obvious reasons these two can be difficult or less ideal in practice. Depending on an investor’s personal circumstance, reducing living expenses, therefore lowering the amount needed to withdraw from a portfolio, may be an effective strategy. Furthermore, a dynamic withdrawal rate may be utilized whereby an investor might spend less if the portfolio drops in value or spend more when the investments are doing well. A few examples may be postponing a big vacation or doing a home renovation project at a later date. Spending less, especially in a time when inflation has caused basic living expenses to rise, is challenging but it may help maintain a sustainable withdrawal rate. If retirement is on the horizon and an investor’s portfolio has significantly dropped in value, working an extra year or two can allow for investments to potentially rebound and time to save more money.
Conclusion
Investors have many tools that they can lean on to assist them leading up to and in retirement. Understanding your goals, personal situation, risk tolerance and options are important. Here at Howe and Rusling, we are always here to listen to your needs, explore your options and provide clarity on how those options impact you.
Disclosures: This material is for informational purposes only and should not be construed as investment advice or a recommendation to buy or sell any security or adopt any specific investment strategy. The information contained herein has been obtained from sources believed to be reliable but is not guaranteed as to its accuracy or completeness. Past performance is not indicative of future results. All investments carry risk, including the possible loss of principal. Diversification and asset allocation do not ensure a profit or protect against loss in declining markets. The examples presented are hypothetical and for illustrative purposes only. They do not reflect actual investments or the impact of taxes, transaction costs, or fees. Investment advisory services are offered through Howe & Rusling, Inc., an SEC-registered investment adviser. Registration does not imply a certain level of skill or training. Clients should consult with their financial advisor to ensure that any strategy, investment, or decision is consistent with their specific situation, risk tolerance, and financial objectives. Fixed income investments are subject to various risks including credit risk, interest rate risk, reinvestment risk, and inflation risk. High yield securities (junk bonds) carry a greater risk of default and more volatility than investment grade securities. Howe & Rusling, Inc. does not provide legal, tax, or accounting advice. Clients should consult with qualified professionals in those areas for guidance specific to their situation.
