Will your retirement accounts survive the next downturn?
A reporter asked Mike Tyson if he was worried about Evander Holyfield and his “fight plan.”
He famously answered; “Everyone has a plan until they get punched in the mouth.”
Maybe you’ve got a great plan for your retirement portfolio. You saved up some money to fund your twilight years.
What if the stock market takes a huge, steamy dump just as your transition to retirement?
You just got punched in the mouth!
What can you do about that?
Disclaimer: I am not a certified financial planner. This post is a quick overview of complicated financial topics. You’ll have a better idea how to protect your portfolio and navigate withdrawing retirement funds after reading this. If you want a more thorough understanding of these issues, however, I recommend reading the source materials I’ve linked to and/or talking to a financial planner about your specific situation.
I believe in the 4% rule, and it’s my spending plan for retirement.
According to the Trinity study, you are safely able to withdraw 4% of your retirement portfolio each year with very low risk of ever running out of money.
The times where you could run out of money are fairly predictable.
It’s when large losses to your account occur in the first several years you are taking withdrawals.
You can greatly mitigate this problem and increase your chances of funding the rest of your life by practicing these two simple steps:
- Lower volatility by gradually shifting to more conservative investments.
- Adjust withdrawal amounts based on sequence of returns risk.
I’ll explain each of these thoroughly.
Lower Volatility as you Approach Withdrawing for Retirement
Most people, including me, invest in 100% stocks. When I say stocks, that includes mutual funds and index funds.
We often don’t have any fixed income (bonds and treasury bills) in our portfolio as a hedge against volatility.
For the thrift savings plan (TSP), this mean you are only invested in funds C, S, and I, and haven’t put any G or F (fixed income) funds in as a hedge.
This is not necessarily the wisest way to invest your money long-term.
While your portfolio has the most freedom to grow quickly invested 100% in stocks, it is also susceptible to sudden market drops.
This is particularly dangerous during the riskiest period for your portfolio, which is around the time you start withdrawing from your retirement accounts.
This is why it is wise to put a specific percentage of bonds or treasuries (fixed income) into your portfolio to lessen the volatility as you near retirement.
If your portfolio loses 50% of its value the year before you need it, you’re screwed.
Having a certain percentage of bonds in the portfolio would cause that 50% drop to be proportionally lower. The higher percentage of bonds, the less the drop.
Unfortunately, the converse is also true. When the market goes up 50%, depending on your concentration of bonds in the portfolio, it will grow less.
This might seem straightforward, but it’s a complicated balance to get right.
You need to worry about these two competing principles at the same time:
- The need for safety and capital preservation.
- The need for growth to hedge inflation over the rest of your life.
Here is some simple guidance for achieving that.
It can protect your nest egg as you approach the age you start withdrawing from your retirement accounts.
The Law of 100
It’s not really a law, but a widely accepted rule-of-thumb preached by financial planners going back several decades.
When it comes to the percentage of your portfolio that should be in stocks, you subtract your age from 100.
A 30-year-old would have 100 minus 30, or 70% of his/her portfolio in stocks.
However, people are living longer, and this amount of money ends up needing to last longer than in the past. Many advisors now suggest you subtract your age from 110 or even 120 in order to have a more aggressive portfolio longer.
I recommend choosing one of these three numbers, 100 (conservative), 110, or 120 (aggressive) based on your risk tolerance. Ask yourself these questions:
Do I have a higher or lower risk tolerance than other investors in my age group?
Is this my only source of income in retirement, or do I have a pension, real estate, or other income as a supplement?
For me as a retired military member with a pension, I’m comfortable using 120 for my calculation.
If you are doing this in a retirement account, you can rebalance to the new percentage each year using this rule without creating a taxable event.
This is a manual method to do what target date funds, or Lifecycle (L) funds in the case of the TSP, do for you automatically.
Target date funds periodically adjust to more conservative holdings as you approach your targeted year. In the case of the TSP, this happens quarterly.
But for do-it-yourself investors like me, I want control over what’s in my fund, and exactly how and when it’s balanced.
This is how you lower volatility using fixed income (bonds or treasuries). You can easily buy these in mutual funds or ETFs at almost any investment firm.
My favorite investment firms are Vanguard, Fidelity, and Schwab.
If you are a military/federal employee, you can buy these funds in the TSP through the G (treasury) or F (bond) funds.
Sequence of Returns Risk Defined
You know how to adjust your portfolio appropriately as you approach withdrawing money for retirement.
This will drastically aid your ability to fund the remainder of your life.
You still need to watch out for sequence of returns risk.
Sequence of returns risk can either hurt you or help you, depending on when it happens.
It can mean the difference between running out of money half-way through retirement, or ending up with 8 times the money you started with.
If you understand it, you’ll be able to adjust your withdrawals correctly and either avoid ruin or take advantage of prosperity.
During your retirement years, if a large amount of negative returns years occur when you begin withdrawing, it will have a lasting negative effect and could drastically reduce the amount available to you. Your portfolio could run out before you do.
Conversely, if a high amount of positive returns occurs at the beginning of your withdrawal years, the opposite can happen. Sticking to the 4% rule in this case, you will end up with much more money than you needed.
How long a portfolio can last in retirement when taking withdrawals has much more to do with the sequence, or order, that returns occur as opposed to the annual average rate of return.
You can end up with far more money than you anticipated. This is due to the critical importance of the sequence of returns in the first few years of withdrawals.
This is what is known as sequence of returns risk.
Sequence of Returns without Withdrawals
This illustration shows how the order returns occur in (sequence of returns) without withdrawals doesn’t affect the end value of the portfolio.
In the case of Mr. Green and Mr. Brown, both started with a $1 million dollar portfolio and had on average 6% returns over the next 25 years.
The order that these returns happened in are reversed for each person.
In this first example, no money is withdrawn and the funds simply grow on their own.
Mr. Green starts with three good years, and Mr. Brown with three bad years.
You’ll see that the sequence of investment returns has no bearing on the portfolio value in the end.
This is because no money was being taken out of the account while it compounded and grew.
Even though one account started with good returns, and the other started with bad, the result was still the same.
Only the average annual rate of return matters in the end, no matter what order it happened in.
Sequence of Returns with Withdrawals
Let’s see what happens in the same situation while both people take 5% distributions (withdrawals) from their accounts each year. Mr. Green starts these withdrawals in an up market.
Unfortunately for Mr. Brown, he starts his withdrawals in a down market and runs out of money before the 25-year point.
Mr. Green on the left ends up with 2 ½ times his original balance while taking out 5% of the balance per year the entire time. This is vastly aided by having up years at the beginning.
Mr. Brown on the right got screwed by the sequence of returns at the beginning of his withdrawal years. Those large reductions to his portfolio balance at the beginning in conjunction with making 5% withdrawals during that time caused a death spiral that was unrecoverable.
How do we avoid these two extreme scenarios?
One where we spent too much and ran out…
The other where we didn’t spend near as much as we could have…
The truth is, the 4% rule is remarkably conservative.
In a majority of historical scenarios, those who withdrawal 4% a year in retirement end up with significant amounts of unspent money in the end.
Of course, if you don’t have your money invested the right way, you’re in trouble regardless. Here’s how to choose the right allocation for you:
Click here for TSP Allocations:
Click here or IRA/401(k)/all others:
How to Avoid Running out of Money
It’s easy to recognize the situation where you are at risk of running out money before the end of your life.
If you have significant down years at the beginning of withdrawal phase, it may be time to throttle back a little. If you are clearly in a bear market, it’s time to withdraw less than the planned 4%.
At a minimum, adjust your withdrawal rate to 3% instead of 4%.
Continue to take less out as long as negative yearly return years continue.
Ideally, you find other ways to get income during those first few tough years. As down years persist, continue to tighten the belt and limit spending more than originally planned.
Taking out even less if possible would put you in a better future position.
Selling taxable investments, start a paying side hustle, or taking on full or part-time work are options for leaving your nest egg as intact as possible during this critical down period.
When you get two positive return years in a row, go back to the 4% rule and use the ratcheting method described in the next section to guide withdrawal increases when indicated.
How to Avoid Underspending – The Ratcheting Method
A far more likely problem while employing the 4% rule for income during retirement is that you will underspend and end up with too much money in your portfolio.
This isn’t a bad problem to have.
You can increase your spending when safe by using the ratcheted spending model as described in Michael Kitces blog post on sequence of returns risk.
I’m going to give a brief overview of his detailed article on this.
A simple way to determine if a higher withdrawal rate is feasible is to increase spending by 10% once the account balance has grown 50% above its initial amount.
For a retiree with $1,000,000, this happens when the balance reaches $1.5M.
In this case, you ratchet up withdrawals 10%.
To avoid ratcheting up too quickly and overspending, only do this every 3 years at most.
This will allow you to take advantage of sequence of returns risk happening in your favor, which is actually far more common than it working against you.
Here is an example of how ratcheting would have worked following these rules over 3 different time frames. In this case, the time frames start in 1966, 1973, and 1982.
Source document: Kitces Blog
In 1966, because of poor returns at the outset of withdrawals, no up ratcheting occurs. This is essentially the flat line you see across the bottom.
The 4% rule was, however, sustainable during the entire timeframe.
In 1973, it wasn’t until halfway through retirement that the first spending increase was indicated. Three more happened after that.
In 1982 we hit one of most favorable sequence of returns risk time periods.
The ratcheting up of spending by 10% each time occurred on 9 different occasions.
Ratcheting up occurs at least once, if not multiple times, in almost all historical scenarios.
In summary, there are two things you need to do to make sure your money lasts as long as you do:
- Make sure you gradually shift your portfolio to a heavier mix of fixed income (treasuries and bonds) as you approach withdrawing.
- Adjust your withdrawal rate based on the sequence of returns at the beginning.
You know how to adjust your withdrawals for retirement now.
Let’s zoom out a little and make sure you understand the big picture:
Let me know where your investments are and how you will be applying this information to your finances.
Rich on Money