When it comes to retirement, people have a lot of important decisions to make. Overall, the goal is to settle down somewhere safe, affordable, and with opportunities for the things that retirees enjoy doing. One of the various things that every person should fully understand before retiring is how risk of market returns works.
Many professional financial advisors agree that of all risks that retirees face, the order or sequence of returns risk is the biggest. This is simply the order in which someone receives returns on the investments made. While still working, this isn’t a huge concern. At that time, the returns come out the same. However, that can change dramatically once an individual retires.
Here’s a perfect example. If someone has $1 million in four different funds, and they withdraw $60,000 annually over four years, the total would vary significantly between what they have while working and after retiring. Before retirement, an individual would end up with $831,768 left in the funds, while after retirement, they’d only have $720,000.
Even with the accounts earning the same rate of return, that’s a whopping $111,758 difference. The scary part is that’s only over four years. So, for someone in retirement 10 years or longer, the outcome would be far worse. This is why before retiring, people need to consider the sequence of returns risk because, at that time, it matters.
What to Avoid
That last thing a person wants to happen is to lose money in the early years of their retirement. Remember, for every withdraw made, the withdrawal gets hit with compound interest. That amount has to do with the market going down. As a result, that individual would spend their retirement money a lot faster than intended.
After working hard for decades, people should enjoy their golden years. This is why some financial advisors tell them to take a conservative approach to retirement. The advisors suggest this will prevent them from losing a significant amount of money early on. However, if someone’s too conservative, it could create some financial issues.
Unfortunately, the interest rates seen today simply aren’t high enough to get someone all the way through retirement. This is especially true for people who live extra-long lives.
How to Avoid This Risk
The good news: There are ways to mitigate the order of returns risk. The easiest involves taking money out of the stock market. For this, people want to remove the amount of money from the stock market they planned to spend during the first several years of retirement. On the other hand, leaving the money alone during a down market is a great way to avoid the effect of negative compound interest in a market that’s declining.
For current retirees, financial advisors recommend protecting at least five years of income from market declines. However, for those still working, they can consider the number of years they plan to stay employed as part of those five years. For instance, if an individual expects to retire in two years, they only need to keep three years of retirement income out of the stock market.
Now, there’s nothing wrong with protecting even 10 years of income. But anything more than that might have a negative effect on a person’s investment portfolio. There is always the danger of being too conservative with your investments and not achieving a high enough return.
As a good rule of thumb, retirees should minimize the impact that early down-market years would have as a way to improve the chances of living longer than the money saved. Overall, retirees need to focus on achieving three goals. These include increasing withdrawals during periods of inflation, bumping up the retirement savings account withdrawals, and making money in savings last as long as the individual lives.
Monte Carlo Analysis
It can be difficult to wrap one’s head around complex financial topics such as the sequence of returns. Thankfully there is a calculation that takes into account multiple variables such as average rates of return, the sequence of returns risk, volatility, and diversification. This calculation is called Monte Carlo simulations. Monte Carlo works sort of like a weather forecast. It runs multiple simulations on your financial portfolio using historical data and tells you the probability of meeting all of your financial goals without ever running out of money.
The Monte Carlo probability that one is looking for is not a one size fits all approach. It depends if you can change your spending habits or retirement date if the market really falls hard. So some people might need a 95% Monte Carlo number to feel safe while others might be fine with 80% because they know they can always cut spending if they need to.
There are several retirement planning applications out there that can run Monte Carlo analysis on your financial or retirement plan. Two of the better software applications that have Monte Carlo are WealthTrace and eMoney. The nice thing about WealthTrace is that they have a version made specifically for consumers. eMoney is made for financial advisors, but does have a client portal where advisor clients can use a slimmed-down version of their more complex software.
Many Risks, But Don’t Stress
Too many people stress about running out of money in retirement. If you can just wrap your arms around your financial situation using good software or a financial planner, you will sleep much better at night.
