Guidance

RESOURCES TO HELP SHAPE YOUR FINANCIAL FUTURE

Assets in IRAs surpassed $9 trillion at the end of 2017, and defined-contribution assets were closing in on $7.7 trillion, according to the latest data from the Investment Company Institute.

No doubt owing to their enlarged balances, workers are also growing more confident in their ability to retire: two in three workers surveyed in the Employee Benefits Research Institute annual survey said that they are somewhat or very confident in their ability to retire.

But the same forces that are fueling retirement confidence have the potential to work against new retirees in the years ahead—especially higher stock-market valuations. A 2012 study conducted by researchers at the University of Missouri found that workers often retire when the market is cresting. Somewhat counterintuitively , that has the effect of reducing a portfolio’s sustainability, unless the new retiree steers most of his or her assets out of the stock market and into less volatile assets and/or income-oriented investments.

Of course, bumps in the road are inevitable in any investing horizon of 25 or 30 years: Indeed, the past 18 years have been pockmarked by two major bear markets. But for new retirees, those downturns can prove especially painful and even lethal. The reason is what retirement researchers call “sequencing risk” or “sequence of return risk.” That means that encountering big losses early in retirement while simultaneously spending from a portfolio reduces the amount of assets that are in place for the market’s eventual recovery. Retirees who encounter a weak market environment later in their retirement years—say, when they are in their late 70s or 80s—are much less at risk for this problem than are early retirees. They have made it through the danger zone of their early retirement years, and their now shorter life expectancies mean their portfolios do not have to last as long.

In some respects, the market environment that you encounter over your own specific retirement horizons is what it is; you do not have any power to control when stocks drop, bond yields shoot up, or spending-power-eroding inflation materializes. But there are a few tactics you can avail yourself of to ensure that if the market gets off to a nasty start during your retirement years, you will not deal your portfolio a death blow. Here are some of the key ones to consider.

1. Delay the date but not the gratification.
If you are eyeing retirement but concerned about eliminating your paycheck in a lofty market that could experience a downturn, one idea would be to start with a work/retirement hybrid—a “victory lap career”—pursuing work that is less remunerative but more meaningful and more enjoyable prior to retiring for good. Alternatively, one investment company has conducted research on a “pre-tirement” strategy, whereby a worker continues in his or her job but spends additional retirement contributions on travel and leisure pursuits rather than saves them. Those late-in-life retirement-plan contributions are less meaningful, from the standpoint of compounding, than those made early on. Meanwhile, the benefits of continuing to work—delayed portfolio withdrawals, delayed Social Security filing, not retiring into an at-risk market—greatly improve a portfolio’s long-term sustainability. Of course, you cannot always decide the date that you retire, and if you are in a job that you hate, it is wise to look for an escape hatch if it is financially viable. But if you like what you do—or can find your way to a paying position that you enjoy—that can help reduce the risk that lofty market returns and low bond yields pose for new retirees today.

2. Seek portfolio balance.
To help circumvent sequencing risk, researchers Michael Kitces and Wade Pfau asserted that retirees’ allocations to stocks should actually start out more conservative and rise over time. Once the retiree is safely through the danger zone of losing a lot of money in the early retirement years, he or she can then increase equity exposure in the portfolio.

That finding was somewhat controversial, but new retirees can partly apply that same concept by setting aside a healthy contingent of their portfolios in safer securities like cash and high-quality short- and intermediate-term bonds. If they do encounter a weak market environment right out of the box in retirement, they can spend from the stable assets while leaving the more volatile assets in place to recover. That is the general thinking behind managing your portfolio in buckets; even in a catastrophic market environment in which stocks fall and take 10 years to recover, retirees would not have to touch the depreciated piece.

But researcher David Blanchett argues that it is important to not go to extremes in structuring a portfolio, instead maintaining balance.

“There’s a decent amount of risk today at both ends of the equity risk spectrum,” he said. “If we think about low equity portfolios, the yields on cash, while they have increased recently, are unlikely to provide the growth required to keep a portfolio going for 30 or more years. Longer-duration fixed-income portfolios could get hurt if/as rates continue to rise. But if the portfolio is too risky and there ends up being a correction, it could significantly affect a portfolio subject to drawdowns.”

In other words, an equity-market shock is not the only scenario to be on guard for; purchasing-power risk and interest-rate risk are also forces to be reckoned with.

3. Maintain discrete holdings to retain rebalancing opportunities.
One takeaway from a series of “bucket portfolio” stress tests conducted by one professional was that at any given point in time—even during the depths of the financial crisis from 2007-2009—something in the model portfolios was doing reasonably well. In 2000 it was value stocks; in 2008, government bonds gained ground. In these portfolio simulations, those appreciated positions provided an opportunity to prune the appreciated portion of the portfolio to use for spending, to refill the cash reserves, or to top up depreciated positions. Of course, you do not want to go overboard in terms of maintaining many small positions. But at a minimum, having discrete U.S. stock, international stock, and bond components, along with a cash sleeve, can help ensure that a retiree never has to tap a position when it is down.

4. Adjust spending downward when encountering retirement turbulence.
The early retirement years are also the high spending years, on average, when retirees indulge their pent-up demand for travel and leisure activities. But a “best practice” emerging from the growing body of research about sustainable withdrawal rates is that retirees should, if they possibly can, rein in their spending amid market downturns. Market volatility in retirement can cause queasiness and a sense that things are out of your control; for retirees, reducing spending is a way to take back control amid the uncertainty. New retirees concerned about impending market volatility could simply start with a modest withdrawal rate; research from Blanchett, Pfau, and Michael Finke suggested that 3% is sensible given still-low bond yields and high equity valuations. (Whether that is a livable withdrawal amount is another story.) Alternatively, retirees could ratchet down their spending if they encounter a weak market, and potentially spend more in an upward-trending one.

 

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