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Dealing With Market Risk Right After Retirement

The greatest retirement plan in the world is not complete if it doesn’t take into account the possibility of bad timing.

The technical term for it is “sequence risk,” and it’s a major threat to your financial well being in retirement. Sequence risk refers to the chance that the economy may take a bad tumble just when you leave the workplace. Such unfortunate timing can wreck your rate of return over the long term.

Consider Joe and Jane, a fictional couple setting up a retirement plan when he is 49 and she is 51. Joe earns $85,000 a year and Jane makes $55,000. She wants to retire in 2016 and he wants to retire in 2023.

The couple, who lives in Virginia, has a 13-year-old daughter planning to attend college. Their nest egg totals $341,500 and includes Joe’s 401(k) plan with $255,000, Jane’s Roth IRA with $68,000, and a 529 savings plan with $18,500 for their daughter’s college education. They are contributing the maximum to Joe’s 401(k) plan, $15,500 a year.

Joe also has a $30,000-a-year pension coming, and both plan to take Social Security benefits at age 66.

Their plan includes three goals:

  • Living expenses. When Jane retires in 2016, the couple wants income of $65,000 (in current dollars) a year from their investments. After Joe retires in 2023 that goes up to $110,000. The plan then assumes Joe will die in 2041, when Jane’s income needs will fall to $85,000. Inflation is factored in at 4.64% a year.
  • College. Since their daughter plans to attend an in-state school, the couple will need $12,573 per year for four years (in current dollars; inflation at 6%).
  • Travel. Joe and Jane want to have $4,000 (in current dollars) available after 2023 for a big trip. Inflation is factored in at 4.64%.

Assuming an average return on their investments of 9.6% over the life of the plan, Joe and Jane will be able to fund all three goals and still have $268,859 in current dollars (this would be $1.69 million in future dollars) left at the end of the plan.

However, that result assumes a smooth progression of market returns, especially in the early years. If the market plunges just as Joe retires, all bets are off. For instance, assume the couple’s portfolio falls 30% the first year after Joe retires and 15% the next year. Even if in subsequent years their returns recover enough to achieve the 9.6% average rate, Joe and Jane will only have enough money for 79% of their living expenses and 35% of their college goal. They would have no money to travel, and no money left over.

The reason? They are starting out with far fewer assets, and so the return they earn builds on a much smaller base. Starting their withdrawals then compounds the problem.

Here’s how to guard against this type of catastrophe:

Change the emphasis. Build asset allocation adjustments into your financial plan. As retirement approaches, a higher percentage of your portfolio dollars should go into less volatile financial vehicles, such as bonds and fixed securities, to mitigate the effects of a market plunge. While you need stocks to protect against inflation, the proportion of stock investments in your portfolio should decline as you get older.

Spread the risk. Diversify both stock and bond investments. Among your stock investments, you may choose a mix of domestic and international stocks and a mix of large-cap and small-cap stocks. In your bond investments, choose a mix of domestic and international corporate bonds, state and municipal bonds, and U.S. Treasury bonds, bills, and notes.

Keep a cash buffer. Set aside six to 18 months of living expenses in cash before retiring, so if the market drops, you can delay withdrawals.

Be realistic. Finally, keep in mind an important psychological factor — when you are young, you can afford to have a high tolerance for risk because you have plenty of years left to make up for downturns. But as you approach retirement, risk tolerance becomes less relevant, and “risk capacity” emerges as the more important consideration. You may still feel psychologically OK with a high level of risk, but you cannot in reality afford it any longer. In other words, if your portfolio takes a 30% hit, you no longer have the capacity to rebound from it financially.


This article was written by a professional financial journalist for Legend Financial Advisors, Inc.® and is not intended as legal or investment advice.

©2018 Legend Financial Advisors, Inc.®. All rights reserved.