As the Market Declines, New Retirees Require a Strategy

You may find yourself in a difficult situation when your portfolio shrinks during the early stages of retirement. However, there are tactics to make the most of the situation.

Anyone recently or approaching retirement must feel like they have the worst luck in the world. When funds are ready to be withdrawn near retirement, a portfolio is often at its highest value. However, most portfolios have declined in value; the S&P 500 is down almost 20% this year.

This situation has a term in the finance industry: sequence of return risk. In retirement, Wade Pfau, a financial planner at the American College of Financial Services in King of Prussia, Pennsylvania, explains it matters most when you sell assets for income. You must sell more shares to earn the same amount of money. Those shares are then extinguished, so your portfolio will not regain as much even if the market recovers.

New York City-based Voya Investment Management’s multi-asset design head, Amit Sinha, says that freshly retired individuals are particularly susceptible because they “rely on this pot of money to support the next 20 to 30 years of their life.”

As a retiree moves to safer, more conservative investments and has fewer years to fund his retirement, the sequence of return risk is less of a problem. In addition, some investors may have profited from early retirement portfolios bolstered by excellent returns.

Similarly, current market conditions are primarily meaningless if retirement is at least ten years away. Sinha explains you just let compounding work for you and recover over the years. A retiree nowadays does not have this luxury. You can mitigate the harm in this scenario, but first, you must determine what it will likely imply for your portfolio in the long run.

Depending on your current response, the harm may not be as severe or long-lasting as you believe.

How Bad Is It, Exactly?

Sinha has run sequences of return risk simulations for every year since 1977, including the financial crisis in 2007 (-51.93%), the dot-com crash in 2000 (-36.77%), and Black Monday in 1987 (-33.50%).

What is the most important takeaway for investors from his research? Do not switch to a cash-only portfolio. Instead of keeping a 40/60 mix of equities and bonds, he compared these savings to what they would have been if the investor had begun retirement with just cash and kept it that way. Even in the worst-case situations of sequence risk, a portfolio of stocks and bonds outperforms cash. In some instances, the first few years were rather difficult, but the investment portfolios were always profitable in the end, explains Sinha.

For instance, an individual who retired at the same time that the dot-com boom burst would have had 10% to 20% fewer savings for the first five years than a cash portfolio. At that moment, the two strategies reached parity. The investment portfolio began to pull away around the 10-year mark, and by the 20th year of retirement, it was worth twice as much as the cash-only portfolio.

Sinha also determined how long these funds would endure, with a significant loss in the first year of retirement, assuming an initial withdrawal rate of 4% and a long-term annualized return of 5%.

Even if your portfolio lost 25% of its value in the first year, it should still be able to endure for 40 years. Despite a 50% loss, your portfolio should still survive 18 years, adding that the probability of a 50% loss in a single year is minimal for a diversified portfolio of equities and bonds.

The markets will ultimately rebound, and so will a balanced portfolio. According to the investment website Seeking Alpha, the average bear market lasts 289 days, but some recoveries occur quickly.

The pandemic provided an ideal illustration. Those that cashed out missed the unexpected bounce, according to Pfau. Pfau recommends recalling how robust returns were in 2021. The markets performed well last year, he said. With this year’s decline, returns will be in line with the 5% to 10% range we expect, as opposed to last year’s gain of more than 25%. When viewed in this light, the performance of your portfolio may not be that far behind.

Your Fortune

What are some prudent alternatives if cashing out now is the worst course of action? Here are various techniques for a mitigating sequence of return risk and preserving your investments.

Reduce your pace of withdrawal. After an initial loss, financial theory predicts that you may remove 4% of your original retirement portfolio and continue withdrawing the same amount annually for 30 years without running out of money. Theoretically, a person who began withdrawing $40,000 annually from a $1 million portfolio immediately before the bear market began may continue doing so now.

But if you play it cautiously, you might withdraw less money. For instance, if your portfolio is currently worth $800,000, you may withdraw just $32,000 per year or 4% of your remaining amount. Pfau recommends utilizing a variable withdrawal approach, withdrawing more in prosperous investing years and less in less prosperous ones. When the market is down, you may adopt the mentality that I will spend less to alleviate pressure on my portfolio. Living on considerably less income may not be practical, but reducing your withdrawals leaves more of your portfolio intact to recover.

Tap non-market assets. Pfau also suggests considering your other assets, such as a reverse mortgage or borrowing from the life insurance policy’s cash value, as alternate sources of income when the market is down. Depending on how much you choose to leave to your successors, you may decide to repay those debts when the market recovers.

Diversify your portfolio further. Greater economic diversity might expedite the recovery of your wealth. If your portfolio consists solely of U.S. firms, you may want to consider overseas assets, adds Sinha. Thus, you are not just betting on the U.S. economy’s recovery.

Consider an annuity plan. You might allocate a portion of your portfolio to an annuity, which converts your contribution into future income to mitigate market volatility. Some annuities provide lifetime payments that are guaranteed and unaffected by market returns. “Creating a non-market dependent source of income can assist lessen sequence of return risk,” says Dave Kloster, Thrivent’s president of investment management.

Pfau recognizes that it may be more difficult to fund an annuity now if your portfolio has suffered losses. He suggests exploring this plan if you still have enough money to purchase an annuity. Alternatively, you might wait until the next market bounce.

Initially, make prudent investments. This next method will not benefit a new retiree at this time but is useful if you intend to retire in the future once the market has recovered. Because portfolios are most susceptible to a sequence of return risk during the early years of retirement, Pfau recommends investing with much more caution at this stage: Consider a 30/70 stock-bond allocation as opposed to the standard 60/40 allocation. Within the first decade of retirement, he recommends progressively increasing the proportion of stocks to 60/40. This technique is designed to avoid the worst-case situation of a massive loss while a portfolio is at its biggest size.

Delay retirement. If you have not yet retired and can continue working, you may wait until your portfolio recovers. You would avoid depleting your funds at a low point and be able to invest a portion of your income at discount pricing. Examine your plan. In times of hardship, having a financial professional evaluate your retirement plan is prudent. “A well-designed plan should be able to withstand market volatility,” adds Kloster.

After hearing the debate, you may feel more confident about the figures and how your strategy should stand up over time. Kloster states this will not be the only era of constriction in our lives. You must be confident in your plan to avoid making drastic adjustments based on market conditions, such as selling cheap and purchasing high, he advises. Find an appropriate degree of risk and keep in mind that market timing is tricky.