Be aware of unique risk facing retirees
During the early years of your retirement, be extra conservative when drawing income from your investments.
The reason is because a drop in the market value of your portfolio, when you begin taking withdrawals, could have a devastating impact on the future value of your investments. This is referred to as the sequence rate of return risk, and is unique for income investors.
Stock market declines create buying opportunities for investors who are saving money. They can buy low, and wait for markets to recover. However, when retirees are dependent upon selling stocks in order to generate income, market volatility works against them. They will have to sell, even if the market is at or near a low. That means they will have less money invested when the market rises. The negative impact of volatility on an income producing portfolio is intensified, if the losses take place early in one’s retirement.
Most investors have heard that stocks have a higher average, annual rate of return than bonds or certificates of deposit over time. The potential problem with this comparison, for retirees drawing income, lies with the term “average annual rate of return.”
There is nothing average about the yearly changes in the stock market. It moves up and down, often with great volatility. If your losses occur early in your retirement year, and you are forced to sell for income at the bottom of the market, you might not come close to experiencing the average rate of return.
Here is an illustration that might be helpful. The stock market was very strong through most of the 1990s. In contrast, the market fell dramatically in the early 2000s and again in 2008. If you calculate the average rate of return of a hypothetical portfolio of stocks and bonds from 1990 through 2008 or in the opposite sequence, from 2008 through 1990, the result is exactly the same. The average rate of return was about 7.5 percent.
However, if you were to have pulled out 5 percent each year and adjusted it for inflation, the sequence rate of return makes all the difference in the world. Using the first sequence which started with a strong stock market, going from 1990 to 2008, a $1 million portfolio would have grown to nearly $2 million despite the annual withdrawals. In contrast, using the same withdrawals, the second sequence which started with a weak stock market, from 2008 to 1990, a $1 million portfolio would have dropped to approximately $500,000. Again, keep in mind, both scenarios used the exact same hypothetical portfolio which generated a 7.5 percent average rate of return. However, the investor in the first scenario ended up with $2 million while the investor in the second scenario ended up with only $500,000.
Why are there such drastically different scenarios in the above illustration? The reason is one investor got crushed in the stock market so badly that he or she was not able to recover because of the income demands placed on the portfolio. Having to sell in a down market, in order to maintain your retirement income, can be devastating, if the losses occur early on.
How do you protect yourself from sequence risk? First, pay as much attention to the volatility of the investment as you do to the rate of return. Consider making a conscious decision to invest in a lower return, lower volatility portfolio because you might not be able to recover from losses in your early retirement years, depending upon your withdrawal rates.
Second, diversify so you are not forced to sell an investment while it is down in value.
Third, err on being too conservative. You are probably not ready to retire if your retirement is dependent upon returns from higher risk, more volatile investments.
Fourth, be able to scale back on your withdrawals in the event of a market downturn. If you do not have the ability to reduce your income in economic downturns, then you probably have not saved enough for a comfortable and secure retirement.