“Retirees wanting to generate most of their retirement income from an investment portfolio should be aware of how the order of investment returns could significantly impact the portfolio’s value.”- Michael Lucey
One of the most significant risks seniors face in retirement is their portfolios’ potential to experience large negative returns soon after they retire. When a person withdraws money from an investment portfolio early in their retirement and has low or negative returns, this is known as a “sequence of returns risk.”
Research done in the early ’90s highlighted that when negative returns occur early in a person’s retirement, they can create a situation where a person runs out of money much faster than anticipated. As a result, retirees generally can’t spend their average return in retirement because the sequencing of returns can quickly drain their portfolios. Making matters worse is that you don’t have to have a market crash to experience sequence risk. Sustained sluggishness in the market, according to some analysts, can be even worse than a huge downturn followed by a recovery.
The return risk sequence means that retirees’ most common fear, outliving their savings, is a real possibility. Therefore, every retirement plan must address the sequence of returns risk and develop a strategy for managing it. While there no perfect plan to avoid this erosive force, there are a few methods you might want to consider.
The 4% Rule- Limit your withdrawals to help your money last longer.
Many people consider the “4% Rule” an immutable tenet of retirement and income planning. With the 4% Rule, you add up all your investments and withdraw just 4% of that total during your first year of retirement. After the first year, you adjust the withdrawals for inflation. Many financial planners adhere to this rule. Based on historical returns, researchers maintain that a person using the 4% rule would not deplete their savings for 30 years.
Income Annuities: Income annuities, because they are not tied to the stock mark and don’t experience interest rate fluctuations, can be a useful hedge against a potential sequence of returns risk. Also, having annuity income lowers the amounts retirees need to withdraw from their portfolios to cover expenses.
Home equity lines of credit or reverse mortgages
While I am not suggesting that you use your home as an ATM, accessing your home equity through a HELOC or reverse mortgage can provide cash relief during a market downturn. In addition, using your equity can ensure that you don’t have to sell off investments in a down year, thus increasing your retirement portfolio’s longevity. However, be aware that reverse mortgages and home equity lines of credit are types of borrowing and come with potential risks and costs. Therefore, you should always consult your experienced financial planner and have them explain the cost structures, benefits, and potential pitfalls of these strategies before you decide.
Many retirees use income laddering to manage the sequence of returns risk. In an income ladder, investors purchase bonds and CDs that have staggered maturity dates. Doing so allows people to access their funds when those CDs and bonds mature without paying surrender charges. And, since no one can accurately predict interest rates, laddering is one way to prepare for the unknown. When appropriately structured, ladders can give you a more secure income than that provided by the market. Annuities can also be laddered, either for yield or income. A popular annuity laddering technique involves the use of “multi-year guaranteed annuities” or MYGAs.
Cash Reserve Bucket
Another way of shielding your portfolio from the sequence of returns risk is through cash value permanent life insurance. Having a cash value policy as your emergency fund allows you to borrow money when you need it, preserving your investment earnings. Life insurance can also have attractive tax benefits and provide other living benefits, such as long-term care coverage. The sequence of returns risk is a real threat that all retirees and pre-retirees must understand and manage. Various strategies exist for mitigating this risk, but each of them has downsides. All retirement and income planning benefits from a relationship with an advisor or team of advisors who understand your money mindset, goals, and risk tolerance. Retirement plans need constant monitoring, and portfolios must be evaluated and balance on an ongoing basis.
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