Whether you’re retiring soon or recently retired, consider these strategies in light of volatile markets and a possible recession.
Like many of us, I frequently heard about someone deciding it was time to retire when the markets were at record levels and the economy was growing. However, financial-market volatility has increased significantly this year and the probabilities of a recession, which Wells Fargo Investment Institute now believes will peak during the second half of the year, are looming. As a result, the landscape for those thinking of retiring or having recently retired clearly may have changed. And that could mean you need to talk to your advisors about your retirement income plan.
Sequence of returns can make a big difference
The challenge for soon-to-be or recent retirees is it’s not only what returns you receive or the withdrawals you take from your portfolio but also when they occur that can have a significant long-term impact on your retirement. This increased risk potential is referred to as a sequence-of-returns risk. To help explain what that means, let’s look at the hypothetical tale of Mary and John, who both started with similar retirements but ended with very different results.
Both Mary and John retired with $3 million in investments, and each withdrew $150,000 from their portfolio at the end of each year. Over a five-year period, they also averaged the exact same 6% average annual rate of return.
The difference, though, was the sequence of the annual returns. Mary experienced a positive return in her first few years of retirement before things took a turn: 16.7% in year one, 31.1% in year two, 9.4% in year three, -1.5% in year four, and -25.6% in year five. As a result, she had $3,030,331.
John experienced the same annual returns, only in reverse order: -25.6% in year one, -1.5% in year two, 9.4% in year three, 31.1% in year four, and 16.7% in year five, resulting in a balance of just $2,626,875. That’s $403,456, or approximately 13%, less than what Mary had — all due to the market decline at the beginning of his retirement.1
A down market may be a game changer
John took withdrawals in a down market early in retirement, which caused his portfolio to be eroded simultaneously by withdrawals and low returns, which can make it difficult to rebuild wealth, even if good returns occur later.
Keep in mind your portfolio is likely to be at or near its greatest value at retirement rather than after you’ve taken withdrawals for a few years. This can leave it at increased risk of adverse market activity. For example, a 25% decline in a $3 million portfolio would result in a $750,000 loss. However, if the same decline occurred later after withdrawals left a $2 million balance, the loss would be only $500,000.2
Taken together, sequence-of-return risk and the potentially higher value of your portfolio mean adverse markets near retirement can have significantly greater effects on savings than if they occur later.
What should you do in today’s down market if you’re thinking about retiring or have recently retired? You may need to revisit your retirement income strategy, especially if your plan is to withdraw a fixed percentage or dollar amount every year regardless of what’s going on in the markets.
One strategy to consider is to maintain a cash reserve in lower-risk accounts that’s equal to the amount you expect to withdraw from your investments over one to three years. Tapping into this reserve instead of your portfolio to cover expenses can help you get through volatile market periods and may leave you with more invested to participate in potential rebounds.
You may also want to review how much you spend. If you are already retired and are able to reduce your spending, you will be able to make fewer withdrawals from your portfolio during market declines. If you are thinking about retiring, now may be a good time to reconsider your spending habits.
Make budgeting a priority
To help with this, start by creating a budget for your retirement. This can not only provide a better sense of your current and future needs but also help you determine how much flexibility you have in your spending by breaking down your expenses into those that are essential (food, housing, clothing) versus discretionary (vacation, dining out, charitable giving), which you can reduce when necessary.
By lowering your discretionary spending and tapping into your cash reserve when there’s market volatility, you may be able to decrease portfolio withdrawals, which may leave you better positioned both psychologically and financially to keep more funds in the market during these periods. If the markets recover, you may be able to return your spending and withdrawals to your planned level but potentially with more assets remaining in your portfolio for use down the road.
1. This information is hypothetical and provided for informational purposes only. It is not intended to represent any specific investment, nor is it indicative of future results. These hypothetical examples illustrate the potential impact of market volatility on a retirement portfolio. Taking withdrawals in a down market causes the portfolio to be eroded simultaneously by withdrawals and low returns, making it difficult to rebuild wealth, even if good returns occur later.
2. Example is strictly hypothetical and not demonstrative of any actual investment’s performance.
Wells Fargo Investment Institute, Inc. is a registered investment adviser and wholly owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company.
This article has been prepared for informational purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Individuals need to make their own decisions based on their specific investment objectives, financial circumstances and tolerance for risk. Please contact your financial, tax and legal advisors regarding your specific situation and for information on planning for retirement.
All investing involves risk including the possible loss of principal. Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve.
Diversification does not guarantee profit or protect against loss in declining markets. Asset allocation cannot eliminate the risk of fluctuating prices and uncertain returns.