Account Withdrawals In Retirement: Know The Risks

When it’s time to retire, many investors find that their years of savings were just the start of their retirement journey. Phase 2 is to invest those assets so that they provide a livable income in retirement for possibly 2 or 3 decades.

One of the biggest risks to a healthy, prolonged retirement is when your portfolio experiences negative returns in the “drawdown phase” – especially in the early retirement years.

That’s when you have the most capital invested and where your money needs to last for the longest amount of time. Early retirement is also often the period when people are drawing the highest income out of their retirement plans, as they adapt to an active, new lifestyle. These downward pressures can significantly reduce the amount of projected retirement savings.

The effect on a portfolio of a period of negative returns in early retirement is called Sequence of Returns Risk. There are ways to potentially mitigate it, but first let’s first understand how it affects a portfolio.

What Is “Sequence of Returns Risk”?

Bad timing is one of the biggest risks that comes with retirement account distributions. Even with a conservative withdrawal strategy (4 - 4.5% per year is the standard) and if combined with a market downturn early in retirement, those first withdrawals could potentially negatively impact your portfolio and income strategy for the duration of retirement.

The table below lists historical average market performance during bear markets and market corrections since World War II. It also shows the length of time they lasted on average and the time for a portfolio to rebound to the pre-drop levels.

Source: CNBC January 2018. A bear market is one in which the market drops more than 20%. A market correction is when the market drops more than 10%.

Liquidating assets when the portfolio is at a lower asset value due to negative market performance crystalizes the loss, so the smaller portfolio generally has a more difficult time recovering.

Let’s look at a hypothetical portfolio experiencing two different return environments in the first four years.

Scenario A:

Scenario B:

Source: Seven Group

These portfolios experienced the same returns – just in the reverse order. Over the four-year period, the portfolio that experienced the negative returns first was down almost $75,000 compared to the portfolio with the higher initial return stream. That’s almost twice the withdrawals – and over time, without many positive returns – it could be a significant problem for future income.

Reduce Risk Through Asset Allocation

One way to mitigate sequence risk is through proper asset allocation. Asset allocation divides an investment portfolio into different asset classes such as stocks, bonds, real estate, cash, CDs, annuities and various other non-market correlated assets. Because you’re positioning certain percentages or sleeves of your portfolio outside of the stock market, you may enjoy more protection against sequence of return risk and capture a broader range of returns from different investments.

A diverse portfolio can provide different ways to seek income and returns. When the stock market is taking a summer break and heading south, the goal diversification aims to accomplish is to have enough money placed in other asset classes or categories to better withstand the rocky roads of Baja and market volatility. By being invested in assets that play different roles and are not correlated with each other, you can shoot for more balance in your portfolio that may help withstand changing market conditions.

Use a Time-Bucket Strategy

Another way to help mitigate sequence of returns risk is by utilizing a time-bucket approach to retirement investing. Time-bucketing divides your assets by the timeframe in which you are likely to need them. Funds that will be needed in the immediate future, say three years or so, are primarily held in cash or other short-term investments.

This can help the portfolio to ride out a period of negative returns by avoiding the need to sell off investments in a down market. Investment horizons are generally divided into intermediate-term assets which are held in capital preservation or cash like equivalent strategies that also throw off income and long-term assets that are earmarked for growth. These longer-term assets have the longest amount of time to recover from downturns before they will be needed.

Before using a time-bucket strategy, it’s important to have an understanding of short-term income needs so you can appropriately allocate funds in the correct buckets. While you may miss out on some potential returns by holding years of expenses in cash, the trade-off for increased stability and peace of mind may be worth it.

Creating a Bond Ladder

Diversifying into bonds helps to create less-correlated assets that can potentially perform better when the stock market is struggling. Depending on the fixed income instrument you’re using, it can also provide a source of income from the yield on the bonds. However, bond markets are at the mercy of interest rates, economic data and the Federal Reserve’s actions, which can also prove to be susceptible to some level of volatility.

The goal of a bond ladder is to reduce the interest rate risk by purchasing multiple bonds with different maturities. This might minimize the possibility of the entire portfolio maturing and needing to be replaced in a period in which yields may not meet income needs. In addition, it allows for some flexibility in generating cash flow as each bond matures at a different time. Taken together, they have the potential to provide more predictable inflows of cash.

Consider Using Home Equity

In 2020, 76% of people aged 55-64 were homeowners and for folks aged 65+, that figure rises to 80%. If you’ve paid off your home or it has increased in value, using home equity may be a viable option to avoid selling investments in a declining stock market.

For short term needs a home equity line of credit (HELOC) can be effective because during the draw period, one is only required to repay interest. Generally, draw periods last five to ten years. In this situation, since the goal of a HELOC is to help bridge the gap in income during a down market, recovering markets and rising income can make the future principal repayments more manageable.

If you’ve always dreamed of selling your home and touring the country in an RV, you’re in luck. That passion may be an effective way to reduce risk. Even if you don’t have dreams of saddling up the whole fam in a Winnebego and hitting the open road, selling your home and downsizing or renting can be effective ways to free up needed cash.

Since these strategies stray away from typical income generation, it’s important to weigh the benefits and take all factors into consideration before implementing. Talk to an experienced financial planner to get a better idea of whether this approach would be good for you.

Conclusion

Risk presents itself in every retirement plan.Having an understanding of both your risk tolerance, as well as your income needs is crucial to effectively managing sequence risk.With the many ways to approach risk management, working with a trusted financial planner can help remove complexity and uncertainty around your retirement and investment strategies.

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