The Success (or lack thereof) of a Retirement Income Plan Partly Depends on Luck by Scott Stolz, CFP, RICP (week 41)

 

You can prepare all you want for retirement, but unless you have so much money that you can’t spend it all, part of whether or not you will be “OK” is just plain luck.  Did you retire just in time to experience poor market returns (i.e., 2007 and 2022) or did you retire just before stocks took off (i.e., 2019 and 2023)?  When you are accumulating a retirement portfolio, the timing doesn’t really matter.  You’ll experience both up and down years (mostly up), but over the long run the stock market goes in only one direction – up.  But once you start taking money out to fund your retirement, it can matter a lot.  Given the volatility we’ve seen in the stock market over the last 6 months, this is an important risk to consider.

Let’s assume for a second that you choose to follow the standard annual 4% withdrawal rate to provide your income.  If the value of your investment falls when you begin taking this withdrawal, you start depleting your retirement account faster because you are essentially selling investments when they are down to create the 4% withdrawal.  If this happens multiple years shortly after your retirement, unless you reduce the withdrawal rate, a $1 million retirement account can quickly become $800,000 or less.  That means your initial 4% withdrawal rate is now effectively 5% ($40,000/$800,000).  This creates a much bigger investment hurdle to keep the account value from falling further.  In contrast, someone who saw significant market gains would see their account value increase over time even after the 4% withdrawal.  The only difference between the two investors is the timing of their retirement.  In the financial world, this is known as the sequence of returns risk – the order of which you get returns on your retirement account.

In a 2024 Morningstar study that looked at a bunch of possible market scenarios concluded that 70% of the time that a scenario led to a retiree running out of money was when their retirement account value was lower 5 years after retirement.  On the other hand, only one out of every 25 scenarios saw the retiree running out of money if the value of their retirement account was higher after 5 years.  (How to Avoid Outliving Your Retirement Savings? It’s All in the Sequence | Morningstar

So how do you protect against bad timing?  Most retirees just reduce their spending, thereby allowing them to lower their withdrawal rate.  While that will work, it doesn’t line up well if one of your objectives is to travel while you’re still in your go/go years.  The standard industry solution is to put most retirees in a 60/40 portfolio.  Since bonds are less volatile than stocks, the 40% in bonds will reduce the chances that the account value will fall in value in a given year.  But what if both stocks and bonds fall together – like in 2022?

Since the problem is exasperated by selling stocks when prices are down, part of any solution should be to eliminate the need to sell stocks in those early years, thereby giving time for stock prices to recover.  This can be done in several ways:

1)      Set up enough guaranteed income that you don’t need to touch the rest of your retirement portfolio.  This solution gives the added benefit of allowing you to invest the rest of your portfolio more aggressively – up to 100% if you want (and your advisor’s firm will let you).  As I mentioned in last week’s blog, this is my chosen solution ( (What's So Magical About a Traditional 60/40 Portfolio? by Scott Stolz, CFP, RICP (week 40).  Essentially, the annuities providing the income serve as my 40%.

 

2)      Create various “buckets” within your retirement portfolio.  One bucket contains one-two years of expenses and holds only short-term, safe investments such as money market accounts and U.S. Treasury bills.  This becomes your source for your withdrawals.  Another bucket would be a bit more aggressive and would fund the first bucket once it’s depleted.  A third bucket would be mostly stocks and would provide the growth you need to increase income down the road.

 

 

3)      Set up Home Equity Line of Credit (HELOC) against your primary residence.  Rather than sell stocks, when prices are down, you borrow against the previously established line of credit to provide any income you need in the short term.  Once stocks have recovered, you both pay off the line of credit and take future income withdrawals from your retirement account.  The HELOC serves as a short-term funding vehicle when you need it.

I’ve covered the first solution at length in previous blogs.  I’m not giving solutions two and three near enough space in this particular blog, so I’ll revisit these possible solutions in future blogs.  There’s much more to both of them than I want to cover this week.  No matter what solution you choose, they all give you the flexibility to avoid selling the investments in your retirement portfolio when prices are down.  Or you can just hope your timing is good.  But as the saying goes, “hope is not a strategy”.