Many of us grew up with the concept that making regular, periodic contributions to our retirement account was a sound investment strategy. The idea was that, in a fluctuating market, regularly investing a set amount would enable an individual to buy more shares when prices were low and fewer shares when prices were high.1
Does this mean that taking regular, periodic withdrawals during retirement makes similar good sense?
Actually, it can be quite problematic.
Systematic withdrawals do the precise opposite of systematic investments by selling fewer shares when the price is high and more shares when the price is low. This, in effect, reduces the number of shares that may be able to participate in any subsequent market recovery.
Here's an example.
In the accumulation phase, if a portfolio falls by 25%, it will require approximately a 33% return to get back to its pre-decline value.²
In the distribution phase, if you withdraw 5% of your portfolio for income and suffer the same 25% market decline, you would need to see a 43% market rebound to get back to pre-decline value.²
Sequence of Returns
In the accumulation phase, investors tend to focus on average annual rates of return and less on the sequence of the returns. If you're a buy-and-hold investor, ignoring short-term fluctuations is usually the sound long-term approach.
If you are in retirement, however, you absolutely care about the sequence of the annual returns.
For instance, comparable portfolios might deliver the same average annual return over a 20- or 30-year period, but they could have radically different outcomes in terms of account balance and income production. Generally speaking, negative returns in the early years of your retirement can potentially reduce how long your assets can be expected to last.
American writer H.L. Mencken once remarked that "For every complex problem, there is an answer that is clear, simple, and wrong."
Anticipating a lifetime of withdrawals from a defined asset pool over an indefinite period of time is a complex challenge for which there is no simple solution. Pursuing this challenge can require creative approaches and persistent vigilance.
Planning Solutions
So, how can sequence of returns risk be addressed during retirement? The primary means to alleviate the risk is controlling the source of retirement income. The most traditional method involves creating buckets for short-term expenses, intermediate-term expenses and long-term expenses. Short-term expenses would be covered by assets invested in lower-risk fixed income, while investments dedicated to covering longer-term expenses could be invested in higher risk, but higher investment return, investments such as stocks. By approaching management of the retirement portfolio in this manner, short-term market fluctuations can be absorbed within the less volatile short-term funding bucket, while the long-term assets are allowed to ride the ups and downs of the market.
Another potential solution to address sequence of returns risk is to provide a stable income source to reduce demand on the portfolio. This stable income can reduce the burden on a portfolio, further helping reduce the impacts of market volatility. Income can be provided through purchasing income-producing stocks and bonds or through annuities that provide regular income payments. The annuity alternative can be expensive and complex, though, and consultation with a financial professional is highly recommended before pursuing this option to protect your retirement portfolio.
Adjustments to retirement spending can also provide a means to alleviate the risk. In down market years, your portfolio long-term performance can be greatly improved just by reducing or foregoing your annual cost-of-living adjustment.
Everyone’s situation is different and there is no one-size-fits-all solution. Your best solution can likely be determined through consultation with your financial advisor.
1 Dollar-cost averaging does not protect against a loss in a declining market or guarantee a profit in a rising market. Dollar-cost averaging is the process of investing a fixed amount of money in an investment vehicle at regular intervals, usually monthly, for an extended period of time regardless of price. Investors should evaluate their financial ability to continue making purchases through periods of declining and rising prices. The return and principal value of stock prices will fluctuate as market conditions change. Shares, when sold, may be worth more or less than their original cost.
2 This is a hypothetical example used for illustrative purposes only. It is not representative of any specific investment or combination of investments.