Sequencing Your Assets to Generate Retirement Income
In retirement, timing can be everything. Retiring in a bear market -- as many Americans did in 2008 and 2009 -- can severely impact the income generating capacity of your portfolio over the long term. This phenomenon is not just a casual observation. It is a financial concept known as sequence risk. If you are approaching retirement, you should understand how sequence risk could affect your future and structure your portfolio in ways that minimize its potential impact.
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Understanding Sequence Risk
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Sequence risk involves the order in which investment returns occur, and the impact that this order, or sequence, has on the portfolios of people who have recently retired. The concept works like this: You retire during a period of economic uncertainty. Your portfolio has significant exposure to large-cap stocks, which are down by 20 percent since the day you retired. Since you no longer have employment income, and the bills are piling up, you withdraw $7,000 from one of your investment accounts to cover living expenses. In a bull market, investment earnings would probably replace the $7,000 in 12 months. In this market they will not. What’s more, you have compounded your market losses by reducing principal, which means there is now less money there to grow when the bull market returns.
Building a Bond Ladder
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To hedge, or lessen, sequence risk, you should structure your portfolio to ensure that you do not need to make withdrawals from assets currently invested in the markets. One way to accomplish this through an investment strategy known as bond laddering. A bond ladder is a portfolio of different groups of bonds that mature at regular intervals over a period of months or years. For example, you purchase four groups of bonds: Group A matures in March: Group B in June; Group C in September; and Group D in December. As each group matures, you can collect the interest for your living expenses, and reinvest the principal to keep the bond ladder going. If the bull market returns, you can move your assets out of bonds as they mature, and reinvest in the market for bigger returns. If the down market continues, you can reinvest in bonds and continue to take the interest, with a relatively strong chance of preserving your principal. You have successfully dampened sequence risk by keeping your investment principal safe in bonds.
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Annuities, Pro and Con
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A financial product known as an annuity offers another way to create a regular income stream in retirement so you will not have to chip away at your investment assets in a down market. Annuities are popular among retirees because they act like pensions: An investor pays into an annuity over a period of years and then, upon annuitization, the annuity will provide a the investor a regular income for a predetermined number of years, or in some cases, for life. Annuities come in many different flavors and there is one out there to meet most retiree needs. That said, annuities have certain shortcomings as well. Critics cite their investment limitations, relatively high fees and, in some cases, their limited potential for passing on money to an investor's heirs as red flags. As you fine tune your portfolio in anticipation of retiring in a few years, talk to a financial professional about annuities. Together, you can determine if this product could be a useful tool in stabilizing retirement income and diminishing sequence risk.
Systematic Withdrawal Plans
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Another strategy for minimizing the impact of sequencing risk involves signing up for a systematic withdrawal plan. This is a service offered by many mutual funds to their customers. Systematic withdrawal plans provide predetermined payout amounts to customers at regular intervals throughout the year. The goal of these plans is two-fold: provide retirement income and maintain principal. While such plans still withdraw invested funds, they do so in a way that imposes budgetary discipline and maximizes the investment potential of the remaining principal.
Plan Ahead
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Perhaps the best protection against losing your earning potential early in retirement is understanding sequence risk and how it can affect you. With this knowledge, you can create a retirement plan in which you make no principal withdrawals in the first five years after you stop working. If you will have a fixed pension and a well-funded portfolio, this is an easy goal to achieve. However, if you are like the majority of retirees, it may require some common sense planning. First, make sure you are on track to receive Social Security and Medicare benefits. Then, sit down with a qualified financial planner and talk about your goals for retirement and any obstacles that may keep you from achieving those goals. With proper guidance and planning, you and your portfolio can be well positioned to absorb both the risks and rewards that lie ahead.
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