- As you reach retirement age, you need to consider a different approach to managing your investment portfolio.
- Market fluctuations can result in significant setbacks to your plan to generate income over the course of retirement.
- A retirement income strategy that accounts for sequence of returns risks may help protect against the impact of negative markets.
One of the most important financial decisions you make in life is choosing when to retire. You want to enter this stage of life feeling confident that you’re financially prepared for the future. For most people, this represents the point when their savings and investments must contribute to the “paycheck” that replaces income they previously earned from work.
Because managing assets in retirement can be a far more challenging task than when your focus is on asset accumulation, it’s critical to have an income strategy in place. Unlike when you were younger, you don’t have the luxury of time to overcome temporary market fluctuations by keeping your money invested. Once you retire, depleting a portion of your assets each year for cash flow purposes makes it more difficult to overcome market declines.
Market volatility as you approach or enter retirement is a critical factor to consider as you design a strategy to protect principal while meeting your income needs today and for years to come.
The unique challenges facing retirees
The reward for a well-planned retirement is the opportunity to pursue your interests and dreams. It’s important to position your assets to generate sufficient income to meet those objectives through the rest of your life.
Yet a variety of factors can present challenges for retirees. They include:
- Retirements that are lasting 20-to-30 years or longer. “You need to have a big enough nest egg to meet income needs over an extended period of time, which may necessitate working longer to accumulate that nest egg,” says Tom Hainlin, national investment strategist at U.S. Bank Wealth Management.
- Markets that fluctuate in value. Investors must accept that periodic market downturns will occur. “Market volatility is a real risk for retired investors,” says Shannon Baustian, private wealth advisor with U.S. Bank Wealth Management. “Investors should be careful about putting money to work in a passive fashion and simply hoping that they are on the right side of the markets.”
- Fixed income investments with lackluster yields. Bond yields have been declining over the past 30+ years. “The interest rate environment can make it difficult for retirees to put too much money into bonds,” says Hainlin. “For example, bonds today can’t generate sufficient yields to meet current income needs and also carry a certain degree of risk if interest rates move higher.” Rising interest rates can eat into the market value of bonds held at lower rates.
- The role of taxes on retirement income. Most or all distributions from workplace retirement plans and traditional IRAs are subject to tax at ordinary income tax rates. “Limiting the tax hit on distributions is important to preserve principal to last through the course of retirement,” says John Campbell, senior vice president and east region managing director, wealth planning at U.S. Bank.
These factors underline why investors can’t simply rely on strategies that might have been effective during their working years.
Sequence of returns risk – timing is everything
Sequence of returns is a risk that applies specifically to retirement income planning. The concept is simple – it’s the risk of negative market returns occurring late in your working years and/or early in retirement. At this stage of your investment life, market downturns can have a much more significant impact on your portfolio and your lifetime income strategy.
“Investors always want to be careful about liquidating assets in down markets to meet income needs,” says Baustian. “This is where sequence of returns risk comes into play for income-oriented investors.”
Consider this hypothetical example of two retired investors, both of whom have $1,000,000 invested and plan to withdraw $45,000 per year, adjusted every year by 3% for inflation. Over the course of retirement, their portfolios will generate comparable annual returns, but at different times. For example, the first investor enjoys three years of positive returns (25% in year 1, 10% in year 2, 5% in year 3) before a negative return in the fourth year (-15%). The second investor suffers a decline in the first year (-15%), followed by gains in the three subsequent years (5%, 10% and 25% respectively). For both investors, the same pattern of returns continues throughout retirement.
“Understand where your portfolio is exposed in ways that could put your long-term financial security at risk if markets move in the wrong direction.”
-Tom Hainlin, national investment strategist at U.S. Bank Wealth Management
The first investor benefits by earning positive returns in the initial years of retirement. As a result, the portfolio gains value early on even though assets are sold to generate income. This strong start to retirement allows the individual’s nest egg to generate the desired amount of income for 40 years.
The second investor had the unfortunate timing of retiring in a year when the markets were down. Just that one year of negative returns, occurring at the wrong time, meant the portfolio lost significant value in the first year. Because assets are being sold into a down market, the portfolio can’t recover as it could during the accumulation period, when no money was taken out of the portfolio. This caused significant damage to the investor’s long-term income strategy, with money running out after just 25 years.
Because of the unpredictable nature of capital markets, says Hainlin, “it’s important to develop a strategy that avoids drawing down principal at the beginning of retirement. Once spent, those assets can no longer generate the growth necessary to last through retirement.”
Retirement bucket strategy
“Retirement is a long runway, and you need growth in your assets,” says Campbell. One income strategy to consider is to segregate a portion of your assets to meet your needs through various phases of your retirement. “We often look at ways to separate retirement assets into three ‘buckets,’” says Baustian. These include:
- Liquidity. Carve out assets to meet income needs for the first 3-5 years of retirement. This money should be kept in more liquid assets with minimal exposure to market fluctuations, including cash equivalent investments and short-term bonds.
- Lifestyle. A portion of dollars to meet needs for the next ten years can be invested more aggressively. “These assets are invested using a disciplined asset allocation strategy that can continue to grow,” says Baustian. “Some of the money is regularly shifted to replenish the ‘liquidity’ bucket.”
- Legacy. “The dollars in this bucket can be invested with future generations or key charitable causes in mind,” says Baustian. “There may be more flexibility to invest these dollars in assets outside of traditional stocks and bond.” This is money that can be held until the latter part of your life, again invested with the long-term in mind.
The bucketing approach is an effective strategy to avoid selling assets that can fluctuate in value and are subject to loss in a down market.
Going further, Hainlin also recommends that investors look for ways to generate income that goes beyond traditional bonds and dividend-paying stocks. “Given the current environment where the Federal Reserve is resolute in raising interest rates to combat inflation, it can be beneficial to diversify into investments that have historically performed well in these circumstances.”
Hainlin notes infrastructure-related investments can have the potential to generate competitive and diversified income relative to traditional stocks and bonds. “Select sectors and industries including utilities, transportation and pipeline companies are examples of targeted investments with attractive prospects that can provide differentiated income for retired investors,” he notes.
Think about taxes
Too many retirees fail to consider that taxes can be a significant expense during retirement. You may be required to take larger distributions than you planned because withdrawals from 401(k)s and traditional IRAs are subject to tax at ordinary income tax rates.
“As you plan for your retirement, it can be a good idea to direct at least some of your savings into Roth IRAs or Roth 401(k)s,” says Campbell. If holding period requirements are met, distributions from Roth accounts are tax free. “This can help preserve capital so your retirement assets last longer.”
Be prepared to execute your goals
If you set a retirement date, you don’t want to be forced to change it due to a negative turn in the markets. “You should consider starting to position your assets for retirement about 2-3 years before you reach that date,” says Baustian. “It can even be initiated five years out. You’ll want to evaluate all of the potential sources of income available to you.” Among the issues to consider in the years leading up to retirement are when to begin claiming Social Security, contributions from company pensions, and if there is any deferred compensation that will be available to fund retirement cash flow needs.
Along with assessing potential income sources that can supplement what you need to generate from your own savings, Hainlin says there are other issues to consider. “Understand what your investment portfolio is exposed to that could put your long-term financial security at risk in the event markets move in an unanticipated direction. Interest rates, inflation, energy prices, and government policies are examples of factors that can influence the future path of investment returns. It can be beneficial to broaden your investments and sources of cash flow.”
Hainlin adds that it’s important for those entering or already in retirement to maintain a degree of flexibility. “Of course, increased life expectancy is a welcome social development, but it creates significant challenges in terms of the increasing costs of retirement over time,” says Hainlin. “Add to that the potential for unpredictable markets, and retirees need to be willing to make adjustments over time to maintain their long-term financial security.”
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