After running away money in a 401(k) or IRA for decades, the last thing you need is a stock market downturn in your early golden years. Market sell-offs are always painful, but they’re more risky when they happen early in retirement, when you’re no longer earning a salary and taking money out of your nest egg.
A sharp drop in the value of your stock just as you are selling in a falling market is like a roadblock set up on the ramp to a comfortable retirement. The unwelcome punch of poor performance and cash outflows can hurt your retirement savings and make it difficult for your portfolio to recover. “Those early years are really important. That’s how the math works,” says Rob Williams, managing director of financial planning and retirement income at the Schwab Center for Financial Research.
Wall Street calls this investment peril a sequence of returns risk. The risk is that annual portfolio losses will be concentrated near the start of retirement, when you begin to withdraw funds, significantly undermining your portfolio’s growth potential and its ability to provide stable income for decades despite a possible market recovery. The sequence of returns “can mean the difference between having enough money to last you a lifetime or running out of money or cutting back on the lifestyle you’ve planned,” says Amy Arnott, portfolio strategist at Morningstar. Making the same withdrawals at the start of retirement during a bull market allows you to maintain the value of your account over the long term while rewarding yourself along the way.
A crack in the nest egg
Consider a hypothetical example from Schwab looking at the impact of three bad first years or three bad last years on a $1 million portfolio over a 20-year period. The analysis assumes that an investor withdraws $50,000, or 5% of the portfolio, at the start of the first year of retirement, then from the second to the twentieth year withdraws the same amount plus an increased withdrawal to account for a annual inflation rate of 2.5%. . The unlucky early childhood investor who suffers 15% losses in each of the first three calendar years after retirement and then earns annual returns of 10% each year thereafter would run out of money on the 18th year. But poor year-end an investor who earns 10% annual returns for the first 17 years and suffers 15% losses in years 18, 19 and 20 would have a balance totaling $1.34 million. the 20th year.
What explains the wide disparity in results? The combination of mediocre returns and distributions in the early years of retirement — what Wall Street pros call the red zone — can prematurely deplete an account’s balance. “Wallet withdrawals compound losses,” an analysis from fund management firm BlackRock found.
Taking distributions from equity holdings in a bear market hurts in two ways. First, you will need to sell more shares to generate the income you need than you would if the stock price were higher. Second, after the sale, you have less stock left that can benefit from the next favorable market. “You miss the rebound,” Arnott says. The multi-year stock market declines that occur in the 70s and 80s after years of positive gains, she notes, are less damaging. Why? Your portfolio has already benefited from years of growth thanks to the composition of returns. Plus, you have fewer retirement years left, reducing your chances of running out of money.
The good news? It is rare for the US stock market to suffer several consecutive years of decline. According to Morningstar, there have only been four periods in the past 93 years (1929–32, 1939–41, 1973–74, and 2000–02) in which the market fell for at least two consecutive calendar years. The bad news? “When this happens,” says Arnott, “it can cause you financial hardship and significant damage.”
One way to ensure that a crack in your nest egg doesn’t completely shatter your portfolio is to avoid retiring with 100% of your investments in stocks, says Arnott. For example, a new retiree with an all-stock portfolio of $1 million at the end of 1999, making annual withdrawals of $40,000 (with 2% increases to account for inflation in subsequent years), would have seen the account lose almost half of its value during the bear market of 2000–02, according to Arnott. And selling stocks during the multi-year recession would have made it harder to profit from the market’s 28.4% gain in 2003.
To cushion a potential hit from sequence of returns risk, make sure you have a healthy exposure to low-volatility fixed-income assets, such as bonds and cash, which provide more stability to your portfolio. Not only will your portfolio experience less volatility and fewer losses, but you’ll also be able to access cash without having to sell stocks when prices are depressed. It’s also a good idea, Arnott says, to set aside a bucket of cash equal to one or two years of living expenses so you can ride out a long market storm without having to sell stocks.
Don’t be too conservative. In fact, according to mutual fund company T. Rowe Price, you can mitigate the risk associated with the sequence of returns simply by building up a larger nest egg closer to retirement. The argument is that a more growth-focused, equity-focused strategy would generate larger account balances than more conservative portfolios, leaving investors with more money even after the market declines at or near the bottom. start of retirement. For example, a newly retired investor with a portfolio of $900,000 who suffers a 5% loss will see the balance drop from $45,000 to $855,000. Another retiree with $1 million who lost 10% would still end up with $900,000. “There’s a trade-off in favor of a more conservative slide path,” says Kim DeDominicis, portfolio manager for T. Rowe’s target date funds.
Unlucky investors on the wrong side of a market return streak can protect their portfolios by reducing the size of their retirement account distributions, especially equity holdings. If you originally planned to withdraw 4% from your portfolio each year, go back to 3% or 2% in years when the market is down. You can also choose not to increase your withdrawal amount to account for inflation. In the worst case scenario, you could ignore withdrawals altogether. “Do what you can to reduce the downward pressure on your portfolio,” says Williams of Schwab. “Don’t give yourself a raise.” If necessary, he adds, cut spending on things you don’t need