This is a guest post by Mike Piper.
Imagine this scenario: An investor (we’ll call her Susan) retires with a $700,000 portfolio. She plans to withdraw $28,000 in the first year of retirement and adjust that amount upward each year in keeping with inflation. In other words, Susan is using a 4% withdrawal rate–typically considered to be sustainable over a 30-year retirement.
Susan’s not looking to get rich, so she uses a moderate asset allocation for a new retiree: 40% stocks, 60% bonds.
In short, Susan is doing everything right — playing it "by the book" in every way.
Unfortunately, in the first year of Susan’s retirement, the stock market tanks, and her total portfolio declines by 16%. Obviously not a good year, but also not exactly a catastrophe.
Or is it?
The 16% decrease from the market coupled with the 4% withdrawal leaves Susan’s portfolio at just 80% of what it was at the beginning of the year. What was originally a 4% withdrawal rate with a 30-year time horizon (generally thought to be sustainable) is now a 5% withdrawal rate with a 29-year time horizon (very likely not sustainable).
Sequence of Returns Risk
The most obvious lesson here is one about "sequence of returns risk." Even a modest portfolio decline early in retirement is bad news! And, unfortunately, asset allocation — the most commonly-used tool for controlling risk in a portfolio — isn’t particularly effective at alleviating sequence of returns risk.
But there’s also a lesson to be learned about the necessity of paying attention. There are a few things Susan can do to get back on track:
- Cut back on spending,
- Purchase a single premium immediate annuity with a portion of her portfolio, or
- Find a way to increase her income.
But if Susan doesn’t notice the significance of that 16% portfolio decline, she won’t make an appropriate course correction. And if she doesn’t do that, she’s very likely to run out of money during her lifetime.
Planning Must Be Flexible
I’m a big fan of John Bogle’s famous admonition to "stay the course" when investing. But it’s worth noting that a strict "rebalance and continue as planned" approach probably would not work in Susan’s situation.
While the wholesale abandonment of a well-constructed investment plan is generally unwise, rigidly sticking to a plan and refusing to make adjustments isn’t a great route either.
Say No To Management Fees
If you are paying an advisor a percentage of your assets, you are paying 5-10x too much. Learn how to find an independent advisor, pay for advice, and only the advice.