Last weekend the Wall Street Journal had a short article titled Beware of Winging Your Retirement that emphasized giving thought to the non-financial aspects of retirement before reaching this major milestone. The upside to those who envisioned and planned for their future? Greater life satisfaction. From the article:
But in talking with and hearing from hundreds of retirees through the years, I have found that those who are most satisfied with their lives spent at least some time thinking and talking about their hopes for the future—typically, several years before retirement itself—and then took specific actions to move closer to those goals.
This is exactly what we do as part of our financial blueprint process to help clients plan for their future. Or, as someone recently described it, we help them integrate their financial plan with their life plan.
But here I want to highlight, in addition to the non-financial reasons, a very important financial reason to stop winging your retirement: the sequence of returns risk.
We can’t control the market, but it can have a big impact on the amount we can safely spend in retirement. Using a simple portfolio composed of 50% U.S. Stocks and 50% U.S. Bonds, the chart below from Wade Pfau, Ph.D., CFA shows the safe, 30-year withdrawal rate each year from 1926 through 1986. This safe, inflation adjusted withdrawal rate would have varied between 4.0%, for the unlucky 1962 retiree, to an astonishing 9.8% for the 1982 retiree who benefitted from fantastic markets in the 90’s. (See here for our thoughts on using the 4% rule for retirement spending.)
Timing Really, Really Matters
Now, this is interesting and probably makes intuitive sense. If you’re lucky enough to retire into a 90’s-style bull market, you’ll be able to spend more in retirement.
But what isn’t intuitive for most is just how important the returns right around your retirement date actually are—this is where the sequence of returns risk comes in.
In the next chart, we are looking at the relative importance of any one year’s portfolio returns on the safe withdrawal rate. The example assumes a 30-year career followed by a 30-year retirement.
The red box we call the “retirement danger zone” because, as you can see, portfolio returns in this period have an outsized effect on your nest egg and therefore the amount you can safely spend in retirement. What you should notice is that returns in the year of retirement have over 3.25x the impact as returns a decade before or after this retirement date.
Now, obviously getting good returns here helps out a lot, but on the flipside, being unprepared for a bear market doesn’t leave you time to recover and is going to jeopardize your retirement.
Are You Taking Too Much Risk?
Because we can’t control the returns the market will provide at our chosen retirement date, it, therefore, makes sense to focus on how much risk we are taking with our investments. But, because of the strong returns in the U.S. stock market since 2009, soon-to-be or recent retirees may be tempted to take on more risk with their portfolio. This behavior, called the variable risk preference bias is quite dangerous for those close to retirement due to the sequence of returns risk we just highlighted. A Morningstar study found that:
“[O]lder workers are more likely than younger investors to experience what we call variable risk preference bias. That is, their willingness to take investment risk varies depending on recent stock-market performance.”
“[D]uring the spring of 2007, older workers tend to appear relatively risk tolerant (they prefer a riskier portfolio). But when they took the same risk-tolerance test in the spring of 2009 after a steep fall in stock prices, older workers were much more risk-averse (they preferred a safer portfolio).”
In fact, instead of taking on more risk as certain older investor may be tempted to do currently,recent research (here and here) has shown that a rising equity glide path (meaning exposure to stocks is decreased around one’s retirement date and then increased again later in life—see chart) can improve odds of success especially in some of the worst case (or most unlucky) retirement years.
Ready to Stop Winging It?
In addition to the higher life satisfaction that comes with preparing for your retirement, a reduction in financial anxiety comes from knowing you have a well-designed financial plan in place. Instead of winging it, and quite possibly taking on too much risk with your portfolio, make sure you’ve planned ahead and don’t fall victim to the sequence of returns risk.
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