In theory, a well-funded retirement portfolio should provide a lifetime of steady income. But there’s a little-known risk you need to take into consideration.
When you’re withdrawing funds at the same time that your portfolio is losing value, you can expose yourself to a phenomenon known as sequence-of-returns risk. “The order in which investment returns occur can have a huge impact on your assets long-term if you are adding to or taking withdrawals from your portfolio,” says Rob Williams, managing director of income planning at the Schwab Center for Financial Research. “If you sell assets at depressed prices during the first few years of retirement, your portfolio may never regain that lost ground.”
When you’re in your 40s or 50s—years away from retirement—a downturn may not pose a problem; the typical bear market has lasted a little over a year.
Volatility can be your friend when you’re in the accumulation phase; dollar-cost averaging (investing a fixed amount on a regular basis) allows you to buy more shares when the market is down.
But if there’s a downturn during your retirement, that could force you to sell shares when values are depressed. “That’s like dollar-cost averaging backwards,” Rob says. If you sell when prices are down, that further depletes your portfolio. Then, if the market bounces back, your shrunken portfolio won’t fully benefit from the gains because you’ve sold so many shares. If the decline is steep or lasts awhile, that could make it even harder to recover.
In the chart above, Bill and John each retire with a well-diversified portfolio of $1.2 million and decide to follow the popular 4% withdrawal rule. If their assets grow at 6% per year and they spend 4% in the first year of retirement—in this case $48,000—and then adjust that figure annually for inflation, their assets could last 30 years.
Unfortunately, the market falls 10% in the first year and 10% the following year. Having stuck to their withdrawal plan, they both enter their third year of retirement with a balance just under $890,000.
But a rebounding market would quickly make up lost ground, right? Don’t bet on it. Those continuing withdrawals are a strong headwind. John would need 16 consecutive years of 6% annual gains to get back to where you started. By dialing back his withdrawals to 2% Bill would cut his recovery time to just eight years.
How can you reduce your exposure to sequence-of-returns risk? In theory you could move all your money into low-risk, low-volatility investments upon retirement. However, that could mean abandoning growth potential and possibly winding up in a worse predicament.
A better solution: Move some of your assets into investments that can weather market disruptions, and leave the bulk of your funds invested more aggressively.
Rob recommends keeping a year's worth of expenses in cash, and another three to five years' worth in assets that can be easily liquidated (for example, high-quality, short-term bonds and cash).
With some protective measures in place, you might feel comfortable taking on more risk with the rest of your portfolio.
Should the market hit a rough patch, try scaling back your planned withdrawals. Or forgo inflation adjustments (or perhaps even postpone large expenses). These steps may not have a noticeable impact on your day-to-day comfort level but, compounded, they can help keep your portfolio robust. If you can avoid a major sale of higher-risk investments in a down market—especially early in retirement—all the better!
To increase your level of comfort heading into retirement, you can also consider buying a fixed immediate or variable annuity. A fixed annuity, also called a single premium immediate annuity, offers steady payments at a fixed rate.
Variable annuities, which invest your premiums in the market, are subject to its swings. But Rob notes that many types of variable annuities also include the option for additional extra-cost “riders” that guarantee a certain level of income for life. These Guaranteed Lifetime Withdrawal Benefits (GLWBs) generally insure that your payments will never decrease or stop—even though value of the underlying investments in the variable annuity will be depleted with every withdrawal, and could eventually dwindle to zero.
Note that the GLWB is not a contract value and can’t be withdrawn like a cash value. Riders add to the cost and vary widely based on product and contract. But depending on your needs, the protection may well be worth it. Keep in mind that all annuity guarantees are subject to the financial strength and claims-paying ability of the issuing insurance company.