Temporarily protect your retirement against volatility risk. Here are some retirement- planning strategies.
Construct a bond ladder to add predictability to your income during retirement
Investors can bank on near-certainties in the investing world: markets go up and markets go down. It may sound simple, but this highlights the conflict of timing your investments now versus pursing a long-term investment goal.
In your retirement planning, you can take several steps to help your portfolio handle the market’s ups and downs while still pursuing your financial goals. It’s possible that a lengthy downturn could hit at an inopportune time during retirement, and you may want to be prepared with your best strategy.
Most retirement portfolios are structured to withstand ebbs and flows in the markets. Still, if you’re approaching or already in retirement, the volatility could make you panic. You may realize that your risk tolerance is much lower than you thought. How can you help temporarily protect your retirement from more volatility than you’re comfortable with?
The first step is not to let emotions stemming from market fluctuations drive your investment decisions.
“It’s always important to invest with a rational perspective, not an emotional one,” says Matt Sadowsky, director of retirement and annuities for TD Ameritrade. “Responding to a market correction with an emotional reaction is a bad way to handle your portfolio.”
With volatility in mind, here are several ways to take a less emotional and more rational approach to retirement planning.
No one likes to lose money, but there’s a difference between an unrealized loss in value and a realized loss, and you should know that difference, Sadowsky says. An unrealized loss is the loss you see on your monthly statements—the difference between the price you paid for a stock and the price it’s trading for on the market. But that’s not your actual loss, because as long as you hold the asset, its value could potentially still increase.
In contrast, a realized loss means you sold the asset and took the actual dollars-and-cents loss, the difference between your purchase and sale price.
If you can hold a potentially promising security, you may recoup your unrealized loss and avoid a realized loss, depending on how the security performs. Of course some stocks can and do sometimes decline in price permanently.
Setting up a five-year bond ladder is one way to add predictability to your income portfolio during retirement. Bond ladders essentially stagger your bond maturities to give you more purchasing flexibility. For example, a five-year bond ladder would cover five years of bonds maturing each year. When the bond on one “rung” expires, an investor can then choose whether to reinvest that amount in bond income or in another area of the market. So this strategy helps investors manage the risks associated with interest rates and reinvestment by spreading them out.
Keep in mind that although bond ladders can provide a strategy against risk, they don’t completely eliminate it. And when you’re creating a bond ladder, or any retirement strategy for that matter, take into account your “income floor.” That’s the amount you need in your retirement essential expenses or core needs. Aim to invest your money in a way that will pursue a goal of your income floor at the very least.
If you’re concerned about the gyrations of the stock market, then you should also reassess if your portfolio asset allocation relative to the amount of risk you want to take on is correct, Sadowsky says.
Planning your retirement might mean taking a more conservative approach. For example, if you have a 60/40 mix of stocks and bonds, you might consider shifting to a 50/50 or a 40/60 mix (which may need to be rebalanced if market conditions change). Or your retirement planning could involve moving toward more defensive sectors such as Health Care and Utilities, which traditionally have less volatility. It might also mean allocating a higher proportion of bonds with higher credit ratings and generally lower risk, but remember this will likely lead to lower returns.
Keep in mind that rebalancing could generate capital gains or losses, which may have tax implications that challenge your retirement-funding needs. Consult with your tax professional before you act.
When the market is in tatters, you may find potential opportunities. Some investors look with fresh eyes to favorite stocks that are falling if the markets are responding to outside forces. Such stocks may be pulled down by economic headwinds such as political tensions or currency fluctuations, not necessarily by their own performance. Investors don’t typically put retirement funds in jeopardy by increasing risk tolerance, but if planned stock buys look like they have lower prices, some investors might judiciously consider buying more on the dips.
A down period might also be a time to consider a change to convert traditional Individual Retirement Accounts (IRAs) to Roth IRAs.
“When you have your assets in a traditional IRA that have been significantly reduced by a market downturn, that might be a time to consider converting to a Roth IRA, because you’re paying taxes on a lower amount that’s being converted,” Sadowsky says. “You have to consider if you want to pay those taxes now or later.”
But keep in mind that converting a traditional IRA to a Roth is not for everyone. And again, consider consulting with your tax advisor before converting.
The 4% rule suggests that you might plan to withdraw 4% annually from your portfolio. But this is a guideline, not a law. If your retirement planning includes the 4% rule, even adjusted for inflation, remember that the amount of your withdrawal will change when the market pulls back and the value of your portfolio declines.
Take, for example, a $1 million account that provides 4%, or roughly $3,300 monthly, to a retiree. If the value of that account falls by 20%, and the investor doesn’t change the dollar amount drawn down, she would be taking 5% of an $800,000 account.
“Take into account the longevity of your portfolio by considering a lower withdrawal rate when market valuations are low,” Sadowsky says. “In a boom market, you might be more conservative.”
And as you take money from your retirement accounts to fund your life, be aware of sequencing risk. This is the risk that your portfolio’s value could decline faster depending on which investments you draw down. Essentially, if your portfolio generates poorer performance early on, it could have a more significant impact in the long run than if your portfolio suffers poorer performance later.
Your financial advisor can help you mitigate sequencing risk through your withdrawal strategy.
Moving your assets into cash is usually a go-to strategy in turbulent times, but many investors don’t want to sell stocks at a loss or in a downturn. Many financial professionals suggest that investors keep enough cash in an emergency fund to cover expenses for six months or a year.
In addition, having cash on hand during market volatility can give investors the flexibility to make purchases when an asset they plan to buy becomes available for a lower price.
Buying stock is an investment in a company, and your earnings can rise and fall with the fundamentals and management of the company, not to mention the overall economy. It can be a win-win or a lose-lose situation. Volatility happens, so it’s best to be prepared.
Whether you need a little guidance or a lot, TD Ameritrade professionals can help with your retirement-planning needs.
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