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There’s a particular period when your retirement plan is at the highest risk of being derailed by market forces outside your control. Anyone’s plan can be upset at any time by overspending, bad investment decisions, and other personal actions. But there’s a particular time when retirees and pre-retirees are especially vulnerable to adverse market forces.
The five years before and the five years after your retirement date are when you are most vulnerable to the effects of a decline in your portfolio.
The average annualized return over time for different investments can be found easily, and those numbers can be used to determine the average annualized return for a particular portfolio allocation. But that will tell you only what the portfolio would have earned in the past and over a long period. The numbers won’t tell you future returns, especially over the next few years.
U.S. stocks have an average annualized return of 9% to 10%, depending on the time period and index selected. But they rarely return that amount in any year. Most years, returns of the stock indexes are substantially higher or lower than the average annualized return.
Suppose you retire with a nest egg worth $750,000 that is invested 50% in U.S. stocks and 50% in bonds. You calculated that combined with Social Security benefits and other resources, that nest egg will maintain your standard of living indefinitely if the portfolio earns the averaged annualized return the rest of your life.
But suppose stocks enter a bear market soon after you retire and decline by 30% the first year. Instead of earning 9% on half your nest egg, you lost 30%. Your nest egg declines by 15% if there’s no change in the value of the bonds. The portfolio might decline less than 15% if the bonds appreciate but will decline more if the bonds also lose value.
Instead of paying the first year’s living expenses from returns on the portfolio, you’re drawing down principal. When stocks begin to recover, your portfolio won’t return to its previous high as fast as the indexes will because you’ll be reducing the principal to fund living expenses instead of leaving it all in the nest egg to recover. When you reach year five of retirement, the value of your nest egg is likely to be well below the projections made on your retirement date. You’ll have to make changes in your spending plans or hope that a period of above-average returns will return your nest egg to its projected value within a few years.
A bear market disrupts your retirement plan even if you haven’t retired but are within about five years of retirement. Your plan counts on the portfolio having a particular value when it’s time to retire. A bear market within five years of retirement can put that target value a few years further into the future. Most retirement plans can’t stay the course if a bear market occurs within the first five years of retirement.
There are several ways to deal with the sequence of returns risk in your retirement plan.
Stress testing before retirement is an important exercise. Most retirement plans project the results if events unfold according to the assumptions. You also should project what happens to the nest egg and the rest of your plan if there’s a bear market early in retirement. How severe of a bear market can you sustain without changing the spending plan? How quickly must the markets recover for your plan to survive without changes? What if there’s an extended period of below-average returns, even if there isn’t a bear market?
Stress testing gives you an idea in advance what might happen if there’s a bear market. It also lets you make an action plan to execute if the bear market arrives in the critical time period.
Another good move is to have a flexible spending plan. Don’t load up your spending plan in the first few years of retirement with fixed expenses. Plan to reduce your spending if there’s a bear market. You might postpone travel, dine out less often or reduce other discretionary spending until your plan is back on track.
Some analysts advocate another strategy to reduce risk. They say you should gradually reduce the percentage of your portfolio that’s in stocks and other risky assets as you approach retirement and have a maximum of 15% to 20% of the portfolio in stocks at retirement. Then, gradually increase the stock allocation during retirement. You’ll want a higher stock allocation over time, because you need growth in the nest egg to preserve the purchasing power of the portfolio against inflation.
This advice is the opposite of the traditional advice to reduce the risk in your portfolio as you age. This new advice makes more sense now that life expectancies are much longer and people need to depend more on their own investments rather than employer pensions to fund retirement.