With stock markets stumbling, people who have recently retired, or are about to, may be eyeing their savings nervously.
After all, withdrawing money from a shrinking pool early on in their retirement years could have a devastating effect later on. They could run out of savings.
Fortunately for those who plan to live off the income and capital of their investments, there are well thought-out suggestions on how to avoid these problems. They fall into a category that experts call the sequence of investment returns.
Moshe Milevsky, a professor at York University's Schulich School of Business in Toronto, explored this issue in a 2006 paper titled "Retirement Ruin and the Sequencing of Returns." His solution was to use a portion of a person's savings to buy products that would guarantee a certain income.
Clay Gillespie, a portfolio manager at Rogers Group Financial in Vancouver, offers a variation on this theme: A person approaching retirement should keep a portion of their holdings in cash and GICs – enough money to last three years.
This "bucket strategy" ensures that investors won't have to dip into a portfolio, possibly even selling stocks, when the market is down.
"How you take out your income is really important," Mr. Gillespie said. "In retirement, you have to plan for stock market corrections every single day."
Let's step back a moment and look at that retirement pool. Most people rely on a mixture of government benefits – Canada Pension Plan, Old Age Security – work pensions and savings to provide them with an income. Their savings might be entirely in registered plans such as RRSPs (registered retirement savings plans), RRIFs (registered retirement income funds) and TFSAs (tax-free savings accounts). If they have used up the contribution room in their registered plans, they may have non-registered bank and investment accounts as well.
Given this mix of income sources, chances are retirees will be relying on their investment portfolio for only a portion of their needs, Mr. Gillepsie notes.
"Most Canadians are going to have to use a significant portion of their capital to fund their retirement if they live long enough," Mr. Gillespie says.
Once a retiree decides which pot of money is most tax-effective to draw from, he or she can calculate how much can be withdrawn each year without running out of savings.
Say, for the sake of simplicity, the person has $100,000 and plans to withdraw 7 per cent a year. (That's a little less than the mandatory minimum RRIF withdrawal at age 72.) Suddenly the stock market dives and the portfolio plunges by 13 per cent. Altogether, the portfolio is down $20,000. To get from $80,000 back up to $100,000, it would have to earn 25 per cent, Mr. Gillespie says. Even recovering the 13-per-cent market hit would take a 17-per-cent gain.
"The point is, the only way you could do that is by investing more aggressively," he says. "That's not a good thing to do in retirement."
To avoid this risk, Mr. Gillespie recommends the following. Put one year's needs in a high-yield savings account. "It doesn't matter what pot of money it's in," registered or not, he says. Put the second year's needs in a one-year guaranteed investment certificate, and the third year's in a two-year GIC.
Mr. Gillespie's strategy implies an asset mix of roughly 80 per cent long-term investments such as stocks and 20 per cent cash and short-term deposits.
Now say the market is bad – the retiree draws on the savings account. If it's bad a second year, he draws on the first GIC. With luck the market rebounds in the third year, and the retiree "harvests" some gains to replenish the buckets.
What could go wrong?
If financial markets plunged and bumped along the bottom for two or three years, the investor might panic and sell – the opposite of what the strategy intended. As the retiree draws more heavily on the cash component, the asset allocation will "drift toward more equity," says Alexandra Macqueen, co-author with Prof. Milevsky of the book, Pensionize Your Nest Egg. As it does, it will naturally become more volatile.
Ms. Macqueen, who is working on a second edition of the book, offered the following excerpt:
"Then, if you experience a poor initial sequence of investment returns – so that you have been forced to liquidate all of your cash investment – you might find yourself with 100 per cent equity exposure well into retirement, and possibly deep into a bear market." Not a comforting thought.
This danger is not lost on Mr. Gillespie, but he turns to history for support. The longest downturn in the stock market was 21 months from 1973 to 1975, he says. The second-longest was 20 months from 1980 to 1982. "Bear stock markets don't last forever."
The care required to replenish the buckets, and the potential risk, raise a question: Why not just have a properly diversified portfolio?
Warren Baldwin, senior vice-president of T.E. Wealth in Toronto, offers this example of how a balanced portfolio comprising separate funds or ETFs for each asset class might work. The 40-per-cent fixed income portion would be a mix of cash and short-term bond funds and perhaps some mortgage investment corporations. The equity side would consist of Canadian, U.S. and international securities.
"Now step back and say you have a couple with $300,000 worth of investments in their RRSPs, TFSAs and personal accounts," Mr. Baldwin says. Their 40-per-cent fixed income position is equal to $120,000. "Say they're withdrawing $20,000 a year to supplement their CPP and OAS," he adds. "They have six years of cash sitting in the fixed income side of the portfolio."
Wouldn't that depress their returns?
"The protection from having 40 per cent in fixed income outweighs the potential reduction in returns," Mr. Baldwin says.
In 2008 and early 2009, fixed-income securities rose while stocks fell, he notes. Clients needing money could tap their bonds or bond ETFs and leave their stocks to recover. In some cases, when the time came to rebalance, the fixed-income portion was still a little high, he recalls. "We advised them to sell some of the fixed income and buy more equities."
Not surprisingly, some clients were reluctant to sell bonds that had been doing well and buy stocks in the depths of a financial panic. "What's wrong with selling high and buying low?" he replied.