Monitor Risk

Question: What is sequence of return risk and what can I do to protect my nest egg from this?

Answer: One risk investors and retirees may face is the chance of sequence of returns (SOR) having an impact on future spending power. Even if you’ve been a diligent saver and prudent investor, the possibility of a down market as you enter the draw down phase and how that may affect future purchasing power is a real concern. The good news is that SOR is a risk you can manage with a well thought out plan.

If portfolio losses happen at the onset of retirement, it becomes more difficult to make up sustained losses. Timing is significant because you may not have the ability or time to make up for losses or to replenish assets with earned income. Here are a few ways to monitor your risk.

Build a buffer

There are several ways to guard against SOR risk. What’s right for you depends on overall wealth, asset allocation, needs, and risk appetite.

Start by determining how much you need in retirement to cover essentials, like mortgage payments, groceries, utilities, insurance, transportation, and healthcare. Compare this to income sources including pensions, Social Security, fixed-income assets/bond ladders and cash. If daily expenses are covered by a steady stream of income, you can weather zigzagging markets by simply skipping that next vacation or delaying the purchase of that new car. As an alternative, you could consider downsizing or taking on contract work.

If those options don’t appeal to you, you can further protect yourself by holding a cash cushion equal to six to 12 months of living expenses. Tap that cushion when markets underperform and build it back up when markets outperform.

Create flexibility

Retirees often assume they can withdraw a certain percentage of their total portfolio, increasing that amount every year to account for inflation. Using this formula, a $1 million portfolio and 4% withdrawal rate would provide pretax income of $40,000 in year one and – assuming inflation runs 3% annually – $41,200 in year two, $42,436 in year three and upward from there. This strategy typically works well if there aren’t any surprises. 

Because this rate is set at the beginning of retirement, it doesn’t factor in some of the “what ifs” that might come along. If your wants and needs deviate from your budget or the market becomes unpredictable, your plan may not keep up. In fact, your retirement portfolio may be shrinking just as the absolute amount you are withdrawing is rising. 

You can avoid this by building in some flexibility. Retirees generally spend more in the early years and taper down over time. Revisit spending and withdrawal goals annually and adjust accordingly. If your portfolio experiences a market boost early on, adjustments can be made upward to allow for higher withdrawals. 

Another option is to set a fixed percentage based on the year-end value of your portfolio. This could mean, however, that you’ll have flush years and leaner ones, depending on the market. Alternately, you can establish a “floor” – an amount that can be withdrawn in any market environment to cover your basic needs – and adjust discretionary spending according to your plan’s performance. 

Finally, consider how your income sources will perform in “normal” markets, recessions, or periods of high inflation. For example, Social Security, which generally includes a cost of living increase each year, should hold steady in a variety of economic environments. 

Adjust as needed

The idea is to put your eggs in several baskets, since it’s impossible to know what the markets will do this year or next, much less over 20 to 30 years of retirement. The key is to avoid overreacting when something unexpected comes your way. Even small changes can have a big effect when compounded over the long term. When things do change, take the time to revisit your withdrawal strategy with a voice of reason, like a CERTIFIED FINANCIAL PLANNER™ practitioner. Stay focused and plan accordingly. 

The opinions expressed are those of the writer as of January 7, 2022, but not necessarily those of Raymond James & Associates, and subject to change at any time. Past performance is no guarantee of future results. Material is provided for informational purposes. These views should not be construed as a recommendation for any specific sector or security. Bond prices are sensitive to changes in interest rates, and a rise in interest rates can cause a decline in their prices. Consult your tax professional and financial advisor before making any investment decisions or bond purchases. Risks include, but are not limited to, changes in interest rates, liquidity, credit quality, volatility, and duration. Stocks are appropriate for investors who have a more aggressive investment objective, since they fluctuate in value and involve risks including the possible loss of capital. Dividends will fluctuate and are not guaranteed. There is no assurance that any investment strategy will be successful. Investing involves risk including the possible loss of capital. Asset allocation does not guarantee a profit nor protect against loss. Withdrawals may result in a reduction of your account’s principal. 

“Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™, CFP® (with plaque design) and CFP® (with flame design) in the U.S., which it awards to individuals who successfully complete CFP Board’s initial and ongoing certification requirements.” This article provided by Darcie Guerin, CFP®, First Vice President, Investments & Branch Manager of Raymond James & Associates, Inc. Member New York Stock Exchange/SIPC 606 Bald Eagle Dr. Suite 401, Marco Island, FL 34145. She may be reached at (239)389-1041, email darcie.guerin@raymondjames.com Website: www.raymondjames.com/Darcie.