Imagine its October of 2007. You have spent the last 30 plus years of your life working and saving for this day, the day you retire. You have watched the S&P 500 Index rise steadily over the past five years, climbing from 837.37 to 1561.80, gaining over 12% a year on average. You have watched your 401k grow steadily and feel your nest egg and social security should provide you with a comfortable if not extravagant lifestyle. You work out the numbers and believe withdrawals of about 5% a year should see you through your lifetime.
Then your November statement arrives, and your stock portfolio has dropped 3%. No biggie, we all know stocks fall from time to time. Now its December and your investments shrink another 3%. Okay, you don’t like it, but you have a long time horizon, and know the markets will recover. The January statement arrives, and your nest egg has shrunk another 10%. You are sweating now; a 20% drop means bear market territory. You know you shouldn’t try to time the market, but jeez! February brings another statement that shows another big drop 12%. OMG! What now?
By the end of the great recession bear market in March of 2009 your stock investments have fallen a whopping 56%. Within 18 months of retiring your nest egg is already depleted by nearly 60% when you factor in distributions.
Welcome to the world of sequence of return risk.
Negative market events that can wreck your retirement happen more often than you might think. August 2000 to September 2002 saw the S&P 500 drop 54% over 25 months. January of 1973 to October of 1974 produced a drop of 52% over a 21 month span. December 1968 to June 1970 set you back 33% in 18 months. The greatest market crash of all began October 29, 1929 and lasted an agonizing 38 months. Stock lost 80% of their value and left the US economy in shambles.
Yes, the markets recovered from all of these setbacks and went on to reach new record highs, but for those unlucky enough to retire at just the wrong moment, recovery could be forever out of their reach. The math of losses works against you. A 25% drop in market value requires a 33% gain to get back to even. A drop of 33% needs a 50% recovery to reach even, and a 50% drop in value means you need a 100% gain to be even. We all know those kinds of gains take a long time to accumulate.
The risk that big market losses occur at the beginning of a withdrawal strategy is called sequence of return risk. If you experience a market return sequence of -10%, -25%, +10%, +25% the net result is you have lost over 7%, the communicative rule of multiplication gives you the same result if the returns are reversed. But! Factor in withdrawals and the picture can change dramatically. Your systematic withdrawals work like dollar cost averaging in reverse. You sell more and more shares to fund your spending at low and lower prices.
So how can you protect yourself from such disasters? While there is no strategy that can protect stock investments from going down on occasion, there are some steps you can take to minimize the damage to your long term plan. The first step to avoiding irreparable harm to reaching your long-term goals is to remember that stocks go down, but they don’t stay down.
Having money invested in different asset classes helps. Although the equity portion of your portfolio would have dropped precipitously, owning bonds and holding some cash would reduce the severity of sudden market corrections. Having less exposure to equities will also reduce your returns over time. Still, if you can match an asset allocation to your need for long term returns you might find a ratio that allows you to sleep at night, fund your retirement income, and let you avoid the big mistake of selling at the very bottom of the market.
A Separate Bucket for Income Withdrawals (The solution to poor sequence returns)
Ideally you have planned well for retirement, so instead of having all your retirement nest egg invested for the long term, you have left yourself a cash cushion to fund your anticipated portfolio withdrawal needs for 36 to 48 months, allowing an extra year as a recovery period. Using this strategy your first year withdrawal needs would remain in a money market account and your spending for that first year would come from this account. Your second year of withdrawal needs would invested in one year treasuries or certificates of deposit. So, the second year rolls around and you still don’t have to sweat a bear market, Finally, the third year of anticipated spending is funded with two year treasuries or CDs and the fourth year would be invested in securities maturing in four years. This separate ‘spending bucket’ is what you use for your spending needs.
This strategy would necessitate a cash allocation of 3X or 4X your estimated withdrawal rate. If you believe a 5% withdrawal rate will be safe, then 15% to 20% of your portfolio would be allocated to the ‘spending bucket’. If you believe a 4% withdrawal rate is more appropriate, then that implies a 12% to 16% allocation to the ‘spending bucket’.
Using this strategy, you could have the confidence to withstand most historical bear markets and corrections. Knowing you do not have to sell stocks when markets a low could give you the edge you need to keep the remainder of your investments intact and allow your portfolio time to rebound. It could also allow the remaining portion of your portfolio to be invested more aggressively, improving the likelihood of higher long-term returns.
Don’t Wait Until You Retire
For those nearing retirement you should ideally begin implementing and funding this ‘withdrawal bucket’ well before the day you retire. It would be frustrating to see the stock market drop in the year before you plan to retire. Much better if you would begin shifting some of your investment, 401k, 403b, or IRA investments into a safe ‘spending bucket’ three to four years before your targeted retirement date. Four years before retirement you would move one year’s expected spending into a money market or GIC (guaranteed investment contract). Three years before retirement you move another year’s expected spending, and so forth. Then no matter what happens in the market you should be able to retire when you want and have all your withdrawal needs set aside for the four years following retirement and you could invest the remaining balance of your investment or retirement accounts in equities for long term appreciation. This seems to us a better strategy than selecting a target date fund that arbitrarily moves money out of stocks as you approach retirement age.