It’s natural to want to get out of the workforce when the market is up. But knowing that a stock market reversal, correction or crash can happen at any time can help those nearing retirement prepare for the early years of their post-career life.
You want to manage the risk of a return sequence, or the risk of a market downturn that occurs shortly after retirement and forces you to sell assets early to cover expenses. In turn, that can deplete your portfolio and significantly limit its ability to recover even after the market recovers.
Longevity risk, or the financial risk of outliving your savings, also presents challenges as life expectancy increases. But the risk of a recovery sequence is an immediate threat to early retirees — and, in fact, can exacerbate longevity risk.
If retirees experience significant losses prior to retirement, entering their account balances leaves fewer assets in the portfolio to help offset those losses and subsequent withdrawals. Market downturns that occur later in retirement, on the other hand, may have less of an impact (since those savings don’t have to last as long).
Investors who are comfortable with the risk of sequence of returns are better equipped to properly manage withdrawals from their retirement accounts. In turn, they can rely on their savings to keep them going for decades after leaving the workforce.
Here are three ways you can get ahead of that crash.
Set aside enough cash to cover at least one year of expenses
Generally, savings accounts at brick-and-mortar banks have lower APYs. Fortunately, there is no shortage of money alternatives that offer better returns than traditional bank accounts while keeping money affordable.
These low-risk, highly liquid financial instruments include high-income savings and money market accounts at online banks, interest-free CDs and short- and long-term US Treasury bills and notes.
Ideally, people approaching retirement should set aside enough money to cover at least one year of expenses (if not two to three years). The idea is that if the stock market takes a particularly bad turn in your early retirement years, you won’t have to rely on early withdrawals from your 401(k) or Roth IRA.
The saying “cash is king” didn’t enter the vernacular because it helped secure early dinner specials and barber shop discounts during retirement. Rather, it highlights how having liquid cash provides security and purchasing power during recessions, periods of high market volatility and unexpected life events.
Forget the 4% rule.
For decades, financial planner William Bengen’s famous 4% rule was the gold standard for retirees to grow their savings safely and steadily.
The strategy calls for withdrawing 4% of your savings in the first year of retirement, then increasing that amount in line with inflation in subsequent years. In theory, doing so should result in retirees having financial stability for 30 years.
Today, critics suggest the figure should be closer to 5%. But the issue with the old law is not its statistics. Instead, the problem is twofold:
- American life expectancy has increased by more than 27 percent since 1960, highlighting the persistence of longevity risk.
- The 4% rule base is based on depleting assets in your retirement account for income.
The best way to avoid sequence risk is to build an equity portfolio. Instead of depleting your nest egg through compounding, inflation-adjusted withdrawals, many Americans can increase their chances of generating reliable retirement income by investing in yield-oriented equities — dividend-paying stocks or exchange-traded funds — in a self-directed, tax-advantaged retirement account.
Dividends returned to a Roth IRA, for example, continue to grow tax-free and can generate tax-free dividends for those age 59 1/2 and older after they have been held in the account for at least five years. With this strategy, instead of selling assets to cover expenses, your assets produce a yield that can be used to cover expenses.
Reassess your investments before retirement
Although rebalancing your portfolio during retirement is important, doing so before leaving employees is the most important step in avoiding the risk of a succession of returns. As we grow, our investments should increasingly reflect the need for wealth preservation rather than growth. The more volatile the portfolio, the less susceptible it is to unexpected market events, which cause volatility.
“Usually, a year out of retirement [is when] we’re starting to get cautious,” Kelly Regan, vice president and financial planner at Girard, Univest Wealth Division, previously told Money.
Here’s an example that shows how important rebalancing is: In 2007, about 25% of 401(k) investors between the ages of 56 and 65 had more than 90% of their portfolios allocated to stocks. When the Great Recession hit, the S&P 500 lost more than 51% before bottoming out in February 2009.
Older investors who were heavily exposed to high-risk growth stocks may not have had enough time to recoup those losses before retirement.
The exact asset allocation that works best for you depends on your risk tolerance and the amount of income you will need in retirement. However, in general, financial experts recommend that people in their 60s have a portfolio of about 60 percent, 35 percent bonds and 5 percent cash.
Taking these three steps can help retirees avoid selling stocks in a down market to cover their expenses. After working towards this goal for decades, being prepared is the last step in preventing the risk of a sequence of returns from ruining your retirement party.
More from Mali:
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