As you approach retirement you’ve likely noticed your focus shifting. Instead of working for the weekend you’re making more plans, both long- and short-term. With these life changes comes a necessary change in how you think about and interact with your investment portfolio, as it takes on a larger role in the coming years. Continue reading to learn more about why risk matters as you enter this new phase in your life, and how you can best prepare for these fluctuations.
Sequence of Return Risk
Retirement investing is not without its share of risks, and many people come to expect them as part of the package. As risk is not unavoidable, what really matters is how it impacts a person’s financial plan. Sequence of return risk refers to the order in which investment returns occur, specifically an investor’s risk of receiving negative portfolio returns later in their career and/or early in their retirement. Losses are compounded by withdrawals, making this concept vitally important to the longevity of your portfolio.
If an investor is not adding or withdrawing from a portfolio the order of returns is fairly insignificant—market fluctuation will have the same impact regardless of the order in which it occurs. When someone is either adding or withdrawing from the accounts, however, the order of returns matters significantly.
- Dollar-Cost Averaging is when an investor is adding to their accounts. As markets go up and down, purchasing consistently reduces the risk of buying high and averages their price over time. They benefit when markets go down as they purchase more shares when prices are low.
- Dollar-Cost Ravaging is the opposite. This is when retirees are withdrawing from accounts, and if markets go down, the withdrawal compounds the downside.
This article from Forbes offers some examples to illustrate these ideas. In these scenarios, they find that with no contributions or withdrawals, the returns are identical no matter the order of the market gains and losses. However, when an investor either contributes or withdraws during that time period, they estimate a $20,000–$25,000 difference in worth for a portfolio initially valued at $100,000, all depending on the sequence of returns over a 5-year period. A change of 20-25% in either direction is a significant amount, requiring careful planning in order to maximize benefits and limit risk.
Minimizing Risk
The years leading up to and the first few years of retirement are crucial for investors to make sure their level of risk is appropriately aligned with goals and comfort for risk. While you can never quite avoid risk, there are ways to minimize it.
One method some investors have chosen is called the 4% rule, in which portfolio withdrawal rates are limited to 4%, aside from a yearly adjustment for inflation. The idea is that this would provide individuals with at least 30 years of income, with most portfolios surviving 50 years or longer, even in the face of unimaginable market crashes.
Although a flat 4% withdrawal rate appears on the surface to be an ideal solution to sequence of return risk, there are some drawbacks to consider. For some individuals, 4% of their initial portfolio might not be enough to cover their cost of living, causing funds to be too tight. Other individuals may find that their particular scenario leaves them with an excess of funds near the end of life—income that could have been utilized sooner for a more pleasurable retirement. While it is prudent to carefully plan your finances, unnecessary withdrawal restrictions may prevent you from enjoying your golden years to their fullest.
Start Planning for Your Financial Future
At Midwest Capital Advisors, we build customized financial plans designed to work under a variety of market conditions. Through our regular consultations, we educate our clients on the various factors that can impact their plan, making sure they are comfortable with the path they are following. If you’re approaching retirement and are unsure about your portfolio’s longevity, or if you need help preparing for the years ahead, contact us anytime. Our advisors are here to help you plan for a more confident financial future.