Is retirement starting to tempt you?
Maybe you peer into your 401(k) and think: “Not bad. Should I go for it?”
Perhaps you’ve even run some numbers on a calculator to assure yourself that you can remove 4 or 5 percent of your savings each year for living expenses, or your financial adviser confirms you have plenty of money to last to age 90.You know about the so-called 4 percent rule – the rule financial planners use to make sure you don’t spend too much and run out of money too early in retirement.
You figure you will live within the rule, but stretch it a bit – maybe withdrawing 5 percent of your savings each year. You tell yourself: “What could go wrong? I can take this leap.”
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There’s just one thing. It’s called sequence of returns. And it can go wrong. If it does, instead of your money lasting through retirement, it may run out while you’re still feeling pretty good and enjoying life. This potential disaster increasingly is getting attention from financial advisers. Financial planner Michael Kitces told a ballroom full of advisers at the Retirement Income Summit in Chicago this month that they cannot let their clients ignore the risk.
In a nutshell it goes like this: Typically, when people look at their retirement money with a financial planner, they figure they will invest the money and make a return, or a gain, on their savings every year. So as they go through retirement, each year they will remove some money to live on, but the remaining money will be invested and presumably grow.
Eventually, retirement funds start to dwindle. To keep them from dwindling too fast, retirees are often told to start with a balanced portfolio – perhaps putting 60 percent into stock funds and 40 percent into bonds. If they are more cautious, they may go to 50-50.With these investments, history suggests they should average an 8 percent gain per year. And if they withdraw no more than 4 or 5 percent each year for living expenses, models based on history suggest the savings should last them 30 years.
But there’s a major problem with averages. History is made up of many different periods in time, and although balanced investments have earned 8 percent annually on average since 1926, you can never expect the average to happen in a single year or even a few years. Sometimes there are nasty stretches. During the best periods in history, the return has been 32 percent for a 50-50 mixture of stocks and bonds in a single year. During the worst, people have lost 22.5 percent in one year, according to Vanguard.
Imagine you are the unlucky soul who happens to retire just as one of the losing periods pops up and shrinks your savings just when you need the money. Surprisingly, if you are hit by a bad spell later in retirement, you should be fine because you will have grown your money very well during your early years of retirement, Kitces said.
But if the nasty period happens soon after you’ve retired, the results could be devastating, and financial planners need to have their clients plan for horrible sequences rather than just assuming they can count on average annual gains.
Consider an example pulled from history by David Blanchett, head of retirement research for Morningstar Investment Management. A 65-year-old retires at the beginning of 1972 with $1 million and she feels confident about retirement. She'll take $50,000 a year out of her savings to cover living expenses and each year adjust it up slightly to cover inflation.
The stock market is reassuring. That year it climbs 19 percent, and with bonds, her balanced mixture of investments grows 13.4 percent. By the end of the year, she has about $1.04 million, even though she removed $50,000 for living expenses.
Then along comes trouble. After a period of great enthusiasm about stocks, they drop 14.6 percent the next year. The woman, who is just one year into retirement, loses about 6.9 percent on her stock and bond mixture. The next year, the pain continues. Stocks drop 26.5 percent and her combination of stocks and bonds lose 13.9 percent. By the end of 1974, she has only $614,880 left in savings.
It’s dwindling much faster than the averages suggested it would and yet, she continues to take out funds for living expenses. Over the next few years, stocks are up and down and flat. One year they climb as much as 25 percent, another they lose 3.3 percent. But instead of lasting 30 years – as her pre-retirement calculations suggested they would – she runs out of money at age 88, which is troubling since 45 percent of people live to 90.
Now here’s the strange part. If the two bad investment years that wreaked havoc with the woman’s money had come late in retirement rather than at the outset, she would have had about $2 million at age 95.
It’s all a matter of timing, and bad times in the stock market can’t be predicted accurately. There is one tip for spotting possible trouble, however. When stocks and bonds get overly expensive, they tend to decline or earn very small returns for a few years.
Since we have been in one of those periods, Kitces said retirees thinking about retirement now could be vulnerable to a decline or just measly returns. But guessing when stocks will go down is impossible, and sometimes even when expensive, they can stay that way for years.
What’s the solution? It’s not to try to guess when the market will turn cruel. Even the best pros get that wrong. Instead, the key is to think at the outset of retirement whether you would have enough in Social Security, pensions or maybe annuities or money from a temporary job to cut back spending in a tough period. That allows time to let your stock investment sit untouched for a time so it can grow again once the stock market comes out of its funk.
Kitces suggests thinking about keeping your savings in distinct theoretical buckets. One would contain enough cash for three years so you could avoid tapping other investments in a bad spell. Another would contain four to 10 years of bonds that could produce income that could be tapped without touching stocks.