As many individuals approach retirement, the desire to exit the workforce during a strong market is understandable. However, recognizing that stock market downturns can occur unexpectedly is essential for those transitioning into retirement, enabling them to strategically navigate their initial years outside of work.
One critical aspect to consider is sequence-of-returns risk, which refers to the potential hazards associated with market declines occurring shortly after retirement. Such downturns could necessitate the premature sale of assets to meet expenses, thereby depleting a retirement portfolio and hindering its recovery following any market rebound.
Additionally, longevity risk, or the financial impact of outliving savings, poses significant challenges as life expectancies rise. For recent retirees, sequence-of-returns risk is particularly pressing, potentially intensifying longevity risk’s effects.
When retirees face substantial losses early in their retirement, withdrawing from their accounts reduces the assets available for future recovery. In contrast, downturns that happen later in retirement may have less impact, as those funds do not need to last as long.
Investors who anticipate and prepare for sequence-of-returns risk can manage their retirement withdrawals more effectively, allowing them to rely on their savings over the long term.
Here are three strategies to help mitigate this risk.
Tuck Away Enough Cash to Cover at Least One Year of Expenses
Although savings accounts at traditional banks typically offer low annual percentage yields (APYs), various cash alternatives yield better returns while maintaining access to funds. Options such as high-yield savings accounts, money market accounts at online banks, no-penalty CDs, and U.S. Treasury bills and notes provide low-risk, liquid investment opportunities.
It is advisable for those nearing retirement to set aside enough funds to sustain at least one year’s worth of expenses, ideally two to three years. This preparation allows retirees to refrain from making premature withdrawals from their 401(k) or Roth IRA in the event of market declines during their early retirement years.
The saying “cash is king” underscores the security that liquid cash provides during economic downturns, periods of heightened market volatility, and unforeseen life events.
Forget the 4% Rule
For many years, William Bengen’s 4% rule has been revered as a guideline for retirees to effectively stretch their savings. This framework suggests withdrawing 4% of retirement savings in the first year and adjusting for inflation in subsequent years, theoretically ensuring 30 years of financial stability.
While some critics propose an adjustment to a 5% withdrawal rate, the real issue with the 4% rule stems from two primary factors: the notable increase in American life expectancy by over 27% since 1960, and the foundation of the rule being dependent on liquidating assets to generate income.
A more strategic approach to mitigate sequence-of-returns risk involves constructing a dividend portfolio. This method allows retirees to invest in dividend-paying stocks or exchange-traded funds (ETFs) within a self-directed, tax-advantaged retirement account, rather than making recurring withdrawals that could deplete savings.
For instance, reinvesting dividends in a Roth IRA allows for tax-free growth and potential tax-free distributions for account holders aged 59½ and older, provided the account has been held for at least five years. This approach enables retirees to utilize generated yields for covering expenses rather than selling assets.
Rebalance Your Investments Ahead of Retirement
While ongoing portfolio rebalancing is important during retirement, adjusting your asset allocation before leaving the workforce is crucial in avoiding sequence-of-returns risk. As individuals age, their investment strategies should increasingly reflect a focus on wealth preservation rather than growth.
Kelly Regan, vice president and financial planner at Girard, a Univest Wealth Division, notes that transitioning to a more conservative allocation usually begins about a year before retirement.
To illustrate the importance of rebalancing: In 2007, approximately 25% of 401(k) investors aged 56 to 65 had over 90% of their portfolios in stocks. When the Great Recession hit, the S&P 500 plummeted more than 51% before reaching its lowest point in February 2009.
Older investors with significant exposure to high-risk growth stocks may have struggled to recover from these losses prior to retirement. The optimal asset allocation should align with individual risk tolerance and anticipated passive income requirements in retirement. Generally, experts advise a portfolio composed of about 60% stocks, 35% bonds, and 5% cash for those in their 60s.
Implementing these three strategies can help retirees avoid the necessity of selling investments during market downturns to meet living expenses. After years of diligent planning, being prepared is the final step in safeguarding against sequence-of-returns risk and ensuring a fulfilling retirement.