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No one wants to see huge losses in their portfolios, ever. But suffering large losses soon after retiring is especially damaging to your portfolio and your chances of retirement success.
This is the most vulnerable period for investors – I call it their Achilles heel period. If large losses occur in the early years of retirement, it is very hard to recover. You are no longer contributing to your savings; instead, you are often withdrawing from your accounts for expenses not covered by your Social Security and pension income.
The risk of suffering poor returns in the first years of retirement is called sequence risk. It is the risk that you retire during an unlucky period of poor returns.
How much can sequence risk really hurt?
To illustrate the effects of sequence risk, consider this example of three brothers who retired within a six-year period, each with an initial investment of $1 million placed entirely in Standard & Poor’s 500 index. Assuming that each brother withdrew $60,000 a year, starting as soon as he retired, each would have had the following ending balances as of June 30, 2015:
A Tale of Three Brothers
|Brother||Date Retired||Total Withdrawal||Balance as of 6/30/15|
|Brother 1||January 1997||$1,110,000||$1,566,883|
|Brother 2||January 2000||$930,000||$45,694|
|Brother 3||January 2003||$750,000||$1,583,626|
Source: Steve Esposito Flat Fee Portfolios Data: Morningstar Principia
Due to the crash of 2000, Brother 2 was almost out of money. His million-dollar portfolio suffered a huge loss, and his subsequent withdrawals depleted his savings.
What a difference just a few years can make. Even though each brother followed the same strategy — investing 100% in the S&P 500 and withdrawing $60,000 annually – Brother 2 had a vastly different outcome because of timing.
It is generally recommended that investors dial down risk as they approach retirement by reducing exposure to the stock market. In fact, target date retirement funds follow “glide paths” that do just this. In 2008, however, many of these target date funds were criticized for being too aggressive. Indeed, at the time, 73% of funds with target dates between 2011 and 2015 lost more than 25% of their value. Most investors in these funds were unaware that their money was so heavily skewed toward stocks.
Bonds may not be bold, but they may be best
A prudent approach for people who are nearing retirement or newly retired would be to increase exposure to bonds to help reduce the chance of a large loss.
But many investors are reluctant to do so today. They are concerned that bond interest rates are historically low and prices are high. If interest rates rise, bonds and bond funds will drop in price, resulting in possible losses. Stock valuations, however, are also high, and a large stock market correction would cause more harm to their portfolios.
But let’s put it in perspective. In 2005 when the Federal Reserve raised the federal funds rate eight times from 2.25% to 4.25%, the return of the Vanguard Total Bond fund for that year was 2.4%. Meanwhile, the S&P 500 index lost almost 37% in the credit crisis of 2008.
How to beat sequence risk
So how can retirees protect themselves from sequence risk?
1. Build cash reserves equivalent to at least three years of net living expenses. This is to ensure reliable income if your portfolio needs time to recover from a large loss. The reason for this is to avoid having to liquidate your stock or bond holdings at a permanent loss to raise needed cash. Estimate how much cash you will need — over and above any steady income such as Social Security — and put it in an FDIC-insured, high-yield savings account.
2. View your bonds as shock absorbers as opposed to a source of income. High-quality, short- to intermediate-term bonds are generally recommended to keep your interest rate and credit risk minimized, and to reduce potential losses in the bond portion of your portfolio. Resist the temptation to reach for yield by loading up on longer maturity bonds or bonds with lower credit quality, as these can suffer more severe losses during stock market corrections. In 2008, for example, the Vanguard High Yield Corporate Bond fund suffered a loss of 21.29%.
3. Reduce exposure to stocks as your approach retirement. Studies show that a 30% allocation to stocks might be prudent in those first years of retirement, as it will minimize your volatility. You can then gradually increase your equity exposure over time, particularly if valuations improve. If you have stable sources of income or have a high tolerance for risk, consider reducing your exposure to stocks by 10% to 20% at a minimum.
4. If you are invested in a target date fund, review the prospectus to see how much of the fund is invested in equities or stocks. Look for a more conservative option or add some bond funds to your mix if you need to adjust the overall asset allocation.
5. Talk to a financial planner. Ideally, you should consult with a planner who can assess the best allocation given your goals, and your willingness, ability and need for risk, while taking into account current valuations. He or she will establish a target stock-to-bond ratio and appropriate cash reserves. These will vary based on your level of assets, guaranteed sources of income such as pensions and Social Security, your life expectancy and legacy intentions.
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