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Thinking That Retiring Means You Stop Investing
Since retirement can last for as long as 30 years, your accumulated retirement savings still have time to grow, even after you retire.
When it comes to investing, a common theory has been used to guide people's thinking as to what a reasonable asset allocation should look like at various stages in their life. It is a very simple concept to understand and remember. Basically, you take 100 minus your age, and that's how much you should have in equities, with the balance in less risky investments. Using this simple formula, you would have a larger portion of your savings invested in equities in your younger years and a smaller portion in your later years. For instance, at age 35 you would have 65% of your money invested in equities. At age 70, a reasonable allocation would be 30% to equities. In other words, more of your money is allocated to asset preservation rather than asset growth.
We have learned that equities provide the best protection against inflation and that, over a long period of time, a portfolio with a higher allocation to well-diversified equity investments will outperform a portfolio with more conservative investments. We also know that retirement can last 25 to 30 years and our savings need to continue to grow by more than inflation and taxes — so then why is there so much reluctance to include equities in a retirement portfolio? It comes down to one thing — the amount of volatility a portfolio can withstand during retirement and, more specifically, volatility when there will be regular withdrawals being made from the portfolio.
How volatility can wreck your retirement portfolio
To show the impact that volatility of returns can have on a retirement portfolio with annual withdrawals, we compare two sample portfolios. The two separate portfolios each begin with $200,000 in them, invested entirely in equity investments. Annual withdrawals of $10,000 are made each year. Portfolio A earns a steady 3% each year (after tax and inflation); portfolio B earns negative 12% for the first two years, then positive 15% for the next two years, and this pattern is repeated throughout the retirement years, so there is an average rate of return of 3% (after tax and inflation).
Results: After 19 years, Portfolio B runs out of money and does not have enough to make the full $10,000 withdrawal. Portfolio A still has $99,533 after the $10,000 withdrawal is made in the 19th year.
The reason Portfolio B runs out of money sooner is that the negative returns occur at the beginning of the retirement period. After just two years of withdrawals during two years of negative returns, the portfolio is worth only $136,080. If the sequence of returns for portfolio B had been the opposite, i.e., positive 15% for two years and then negative 12% for two years, with this pattern repeated, the portfolio would have $39,322 in it at the end of 20 years. So to minimize the risk that volatility adds to your portfolio during retirement, many advocate holding a low-risk portfolio. This was an extreme example of how volatility affects a portfolio because it assumes the entire portfolio is invested in equity investments.
Another common approach would be to divide the portfolio into individual portions of money based on when you need it. For instance, if you need $10,000 per year, then you would need to set aside $50,000 for the next five years. This money would be invested in short- to medium term investments to minimize volatility, because they would need to be cashed in over the next five years. The rest of the money (i.e., $150,000) can be invested with more of a long-term approach, which would include a higher proportion of equity investments. This approach may require more frequent rebalancing to ensure that enough funds are moved from long-term investments to short-term investments over time, so that the annual withdrawal can be made when needed while providing some flexibility as to when rebalancing will occur. For instance, if the stock market is in decline, you can delay transferring those investments that have gone down in value and wait until there is a recovery.
Retirement is not a short period of time
When you consider you may only be saving for 25 to 30 years, and retirement can last 25 to 30 years, it's common sense to expect to continue to earn income on your investments during retirement. Unless you are independently wealthy and focused solely on wealth preservation, you will need your savings to continue to grow after tax and inflation so that you can make the withdrawals you require for the rest of your life. In the example above, portfolio A still held $92,519 after making $10,000 annual withdrawals for 20 years. At this point, the entire original savings of $200,000 have been withdrawn, and the $92,519 remaining in the account represents growth in the portfolio. Without the growth, the money would have run out after 20 years.
Rescue it!
During retirement years:
- Ensure that you have a minimum of five years’ worth of withdrawals invested in low-risk, easily accessible investments.
- Keep a long-term view for the balance of your retirement savings.
- Avoid or minimize withdrawals from a declining portfolio by delaying expenses that are not absolutely necessary.
Excerpted from 52 Ways to Wreck Your Retirement…and How to Rescue it . Copyright (c) 2011 by Tina Di Vito. Excerpted with permission of the publisher John Wiley & Sons Canada, Ltd.