Many people scrimp and save for decades in hopes of enjoying a relaxing and rewarding retirement. But one thing that’s impossible to plan for when you are 25 or 30 years out from retirement is this: What will the economy be like when you reach 65, 67, 70 or whatever target retirement age you set for yourself?
If you luck into an economic upswing, good for you. But what happens if you finally reach that magic retirement moment and the market is tanking, inflation is out of control and stagflation has settled in?
In that scenario, retirees face at least two risks that have the potential to tarnish their long-awaited golden years:
- Sequence-of-returns risk, which affects long-term holdings.
- Interest rate risk in your bond funds for fixed income.
The good news is that several strategies exist to help retirees maneuver through these risks and dodge the loss exposure that can rear up at each unexpected turn of the retirement journey.
Retirement Risk No. 1: Sequence of Returns
Perhaps you have run across references to sequence of returns risk before. If not, let me give you a quick primer about how it works – and how it can quickly erode your retirement savings if you don’t take steps to counteract it.
Let’s say you decide to retire at 67. You have a hefty amount of savings to see you through the next few decades – or so you (or your accumulation-oriented financial adviser) believe. But times are tough with the overall economy at the time you retire. If you are confident that won’t affect you (you’re retired, after all, and not seeking employment), you are wrong.
Here’s why. As you enter retirement, there’s a reasonably good chance you will need to begin withdrawing money from your savings right away to help pay for your lifestyle. At the same time, an uptick in market volatility causes the value of your portfolio to decline. You are experiencing a double whammy: The market is going through a volatile cycle, and, for the first time ever, your income withdrawals accentuate those losses.
Perhaps you will look on with shock as your portfolio balance drops, drops and drops some more. Eventually, the market will turn around, but you may have lost so much ground that you can never catch up. In the past, these market dips were great buying opportunities. Now, the opposite effect is playing out.
Contrast this with someone who enters retirement in a great economy. In the first few years of retirement, they see gains in their portfolio, not losses. Yes, they also are withdrawing money, but with any luck, their gains should outpace those withdrawals. If, down the road, the market takes a dip, they won’t be as harmed as you were because of those early years of portfolio growth.
See the contrast? Good market results in the early years of retirement, followed by poor market results in later years, is a survivable scenario. Poor market results early on, followed by good market results later, may not be.
What to Do? Focus on What You Can Control
Obviously, you can’t predict years in advance what the market will be like when you reach retirement. So, what can you do to try to mitigate the sequence of returns risk?
Well, remember, you are withdrawing money from your retirement accounts, so you need to pay attention to which of your investments it makes sense to draw from first.
If your stocks are losing value, you want to avoid tapping into them while the market is down. Instead, turn to less volatile accounts, those that generally protect against loss, such as bonds, CDs and other low-risk investments. Make those your first stop for withdrawals as you wait for stocks to rebound.
Retirement Risk No. 2: Interest Rate Risk and Bonds
While bonds can be helpful in dodging sequence of returns risk, bond funds, a more common investment, do no such thing. These investments come with their own risk. You may even be feeling this effect right now as the Federal Reserve is working to combat rampant inflation by raising interest rates.
Bondholders are currently getting a steady stream of coupon income with the peace of mind that their principal will be returned when their bonds mature. Unfortunately, bond fund holders are watching the value of this portion of their portfolios free-fall. This is because new bonds enter the fund with a higher interest rate, making them more attractive than existing bonds that pay the lower rate. If you want to sell your bonds, you likely will find they don’t command the price they did before interest rates started going up.
This can catch many people off guard because their advisers suggested that bond funds were “safe” investments without explaining that their principal can indeed experience substantial losses in a rising rate environment, like this one.
What to Do? Get the Right Investment Mix
Instead of using a bond fund, invest directly in the bond security. This approach reduces your interest rate risk because the coupon payments stay consistent, and the full investment principal will be returned. You can also invest in CDs or anything else that guards against loss.
Some conservative investors overload their portfolios with bonds (or really, bond funds) thinking they are being safe. I saw this not long ago when a woman in her 60s came to me for help. A previous adviser had set up her portfolio as 20% stocks and 80% bond funds. Her stated goal was to keep her money safe and to take little risk. She was baffled that her bonds were taking more of a hit in the market than her stocks.
It is imperative to seek out a financial professional who can help you find the right investment mix and make sure you truly understand the risks you are facing. These risks change as you shift from working years, with your primary investment goal hinging on accumulation, into a distribution phase.
Whether those risks are caused by sequence of returns, bond funds or something else, you want to do everything you can to minimize the hits to your portfolio, so you can enjoy the kind of retirement you planned for so many years.
Ronnie Blair contributed to this article.
The appearances in Kiplinger were obtained through a PR program. The columnist received assistance from a public relations firm in preparing this piece for submission to Kiplinger.com. Kiplinger was not compensated in any way.
Bradley Geddes is the San Francisco financial planner for Decker Retirement Planning. He is a CERTIFIED FINANCIAL PLANNER™ professional and has over 13 years of experience in financial advisory, capital markets and corporate finance. He also co-founded a SaaS company in San Francisco and worked as the firm’s CFO before moving into this financial advisory role. Geddes graduated from the University of Washington, where he earned his bachelor of science degree with an emphasis in finance.
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