How Market Cycles Can Impact Retirement
Markets go up. Markets go down. But no one can predict when, how, why, or for how long. Ups and downs are par for the investing course, but market cycles can have a greater impact on those nearing or in retirement than those in their accumulation years. That’s because in retirement you simply have less time and fewer opportunities to rebuild your savings should the market take a turn for the worst.
So, in order to understand how market cycles can impact your retirement (and what you can do about it) let’s look at some facts.
Understanding the Impact of Market Cycles
The most noticeable impact market cycles can have on your retirement is in regard to income distribution. When you rely on your investments to generate income, a less than favorable market cycle can dictate how long your money will last. That’s why it’s imperative to determine the optimal spend down of your assets, which can be complex and based on many factors (both known and unknown).
Following that rule in the 1980s and 1990s made sense because bonds and stocks experienced primarily positive returns. It didn’t work quite as well in the 2000s with a largely stagnated stock market, forcing retirees to deplete their assets more quickly.
What complicates this rule of thumb is market volatility, which introduces a greater risk to the portfolio. When retirees are drawing down assets during a declining market period, there is a higher probability their assets will not last as long as they’d hoped. The only remedy then seems to be to reduce the spend down rate, live a diminished lifestyle, or risk depleting their assets too soon. And of course, no one wants to run out of money.
There is even greater risk when the market declines at the beginning of retirement. A steep market decline in the first few years before or after retirement, even if followed by a sustained market increase, can severely impact future income. This risk is referred to as “sequence of returns” or sequence risk and is one that very few DIY investors are privy to. And if they are aware of the risk, they tend not to know how to account for it in their financial plans.
The Greatest Risk Retirees Face: Sequence of Returns Risk
When it comes to retirement drawdown and market cycles, timing is everything. That’s because sequence of returns risk stems from the timing of market returns and their impact on your portfolio when you begin to draw down your assets.
While it is fair to assume that the market will generate an average rate of return over time, that doesn’t account for the timing of those returns. Your portfolio can average eight percent a year over twenty years, but if the first three to five years consist of negative returns, it could be too much to overcome even if the next fifteen years produced positive returns.
Why? Because loss and gain are not inversely proportional. If stocks in your portfolio decline in value, you need to sell more shares to meet your income needs. That reduces the number of shares left to grow inside your portfolio. During a prolonged market decline, that accelerated depletion of shares could make it difficult for your portfolio value to recover as the market recovers.
Imagine your portfolio like an apple tree. Each year you need to take 40 apples from the tree to survive. Based on the tree’s history, this is a safe rate at which the tree will at least replenish if not surpass restoring those 40 apples. But, if when you begin taking those 40 apples out each year, the tree starts to produce fewer apples—you run the risk of using up all your apples before the tree has a change to grow more.
The Risk (or Reward) is Greatest at the Beginning of Retirement
Conversely, drawing down your assets during an advancing market could provide the boost needed to carry your portfolio through future market declines or allow you to live an enhanced lifestyle. That also means if your portfolio experiences negative returns in later years, it will probably have a minimal negative impact.
While you can’t predict the stock market’s direction, much less the sequence of returns as you enter retirement, you can prepare a diversified portfolio that is designed to handle such possibilities. We help our clients mitigate this risk and provide them with peace of mind that the retirement income plan we have built for them will be able to mitigate the sequence of return risk and boost their overall lifetime income sufficiency.