Did you know two people can earn the exact same average return on the exact same amount of money and one can run out of money in retirement while the other could live comfortably and still leave a legacy to the next generation?
How can this be possible, you might ask? It’s because of a risk that most people haven’t heard of and therefore haven’t planned for.
Imagine you retire at age 65 with $500,000 in your investment account(s) and your plan is to take out $45,000 from these accounts each year in retirement. For most, the biggest concern is whether you will run out of money before running out of life. In part the answer depends on luck, and in part a planning strategy can help you if luck doesn’t go your way. What I am describing here is a concept known as sequence of returns risk.
What Causes This?
The sequence of when you have positive returns in your portfolio and when they are negative really matters when you are taking money out in retirement. For example, if you take out $45,000 in a year where the market went up $50,000 at the end of the year, you actually have $5,000 more than you started with. In contrast, if the market went down by $50,000 and you take out $45,000, your account is actually down $95,000 after the withdrawal. If there is a full recovery in the market the following year, you didn’t have as much in your investment account to grow back to where you were.
The Luck Part
One person could retire in a year where their investments went down 40% and another could retire a year later with the same starting amount. With several consecutive positive years thereafter, the first person could run out of money while the second wouldn’t.
We would all think the second person must have been smarter than the first and made good financial choices, but actually they simply got lucky. They retired when the market was friendly while the first person took a big hit and their portfolio couldn’t recover. I’ve run the math, and would happily run through this with you. Just reach out and I’ll spend a complimentary 30 minutes with you on this.
It’s not good planning to hope you get lucky. If luck doesn’t work, the results could be disastrous. What would happen if you run out of money by age 75 and live to 85? Do you have family to rely on, and do you want to ask them for money? Instead of leaving it to chance, create a strategy that will help you.
The Strategy Part
There is a way in which you can minimize the risk. While nothing is guaranteed in life except death and taxes, you don’t want to simply hope that a market crash will not devastate your retirement. Would you want to implement a strategy that would improve your chances of your nest egg lasting through your living years?
The strategy I’m referring to is called a volatility buffer. At its simplest, this is money put aside so that if the market goes down, you turn to the buffer instead of drawing from your investments. This can be cash you set aside as an emergency fund, a line of credit or another asset that isn’t tied to the market. If you can create and access this, you can choose not to draw from your investment portfolio in down years and let the market recovery fully restore your accounts.
In many cases you will want to build the strategy long before retirement when you can. For some who are already retired, it may be putting some of your money into an asset that isn’t invested in the market. Each person’s situation would be different and the ideal strategy for you is something you should build with your financial advisor.
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Disclaimer: All examples are hypothetical and not representative of any specific strategy or situation. This article is for informational purposes only and is not tax, legal or financial advice. Everyone’s situation is different, so consult a financial advisor. If you would like to connect with me, please call 615-619-6919 or email smoran@redbarnfinancial.com. You can learn more at redbarnfinancial.com.
