When considering how and when to draw down your retirement funds, look beyond the 4% rule and consider sequence of return risk.
Dreaming of the day when the morning alarm clock will be replaced by the morning newspaper and coffee on the balcony overlooking the waterfront? Preparing a sound financial plan for your retirement can help ensure you enjoy your retirement years, but how can you know if your nest egg will last a lifetime?
There are many strategies for how to draw down your retirement funds in order to make them last a lifetime, but here are three designed to protect against market risk in the early years of retirement:
How can these strategies help? They address something financial advisors refer to as sequence of return risk. This is a complicated-sounding name for a simple issue. Sequence of return risk simply focuses on the potential for investment losses early in retirement to weaken the ability of retirement funds to generate income to last a lifetime.
"It's not something you need to lose sleep over if you're still adding to and growing your nest egg. But it should be a big consideration if you're approaching or living in retirement and drawing down on your savings over time," says Matthew Sadowsky, director of retirement and annuities at TD Ameritrade.
Sadowsky explains: "If you are withdrawing from the market over time, it hurts more when your portfolio drops in the early years of retirement. There is less left in the portfolio to bounce back when the market goes up."
There are several strategies retirees can use to hedge against this risk. Let's dig deeper.
Retirees can try to isolate a portion of their retirement income plan from market volatility through the purchase of guaranteed income, such as an annuity. An annuity is simply a contract between a guarantor—often an insurance company—and an individual or couple. Growth annuities are issued with either a fixed or variable rate of return, with a focus on the growth of an investor's portfolio. Income annuities may also include a growth component, but the main goal of an income annuity is to create a guaranteed stream of income that cannot be outlived.
There is another type of annuity—the deferred income annuity—that combines the characteristics of both growth and income vehicles into one product. An individual who purchases a deferred income annuity will receive a steady stream of income, almost like a personal pension payment, starting at some point in the future, that will continue for the rest of the investor's life.
Although cash doesn't offer much of a return, it can act as a welcome liquidity source during down market years. "If you have enough cash to tap into, you can choose when to tap into your nest egg instead of being forced to during an inopportune market drop," Sadowsky says.
Another option to hedge against sequence of returns risk is to plan ahead to be more conservative in your early retirement years. "In the first five or so years you might want to be more conservative with how much you withdraw," Sadowsky says.
As Benjamin Franklin said, an ounce of prevention is worth a pound of cure. And when it comes to retirement planning, those ounces can add up, especially in the early years. Now isn't it time for Zumba?
Planning for tomorrow involves setting financial goals today. Are your plans on track?
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