People in their 20s and 30s are often told that they can invest aggressively, especially when they don’t anticipate that they’ll be living on their investments for years. But once you get within 5 years of retirement, I think you should start thinking about preserving what you already have. How do you do that? Part of the process is to understand the threats to your financial wellbeing—like market risk.
Retirement researcher Wade Pfau studied the impact of market risk on retirement income planning by measuring 151 hypothetical portfolios. Each portfolio earned market returns for 30 years prior to the fictional investor’s retirement, the only difference being the actual dates measured. Pfau found that the amount of money accumulated for retirement varied quite a bit, with outcomes ranging from three to 27 times salary, depending on which 30-year period was tested. In other words, he found that when people invest is very important. Specific rates of return in the final years of accumulation before retirement had the most impact on the ending value, i.e. the amount of money earned in the last years before retirement had the biggest effect on an investor’s retirement account.
Pfau then took those same portfolios, and using a constant inflation adjusted withdrawal strategy, he found that the maximum sustainable withdraw rates during a 30-year period after retirement ranged from 1.9 percent to 10.9 percent. The disproportionate withdrawal rates were explained by the difference in returns during the early part of the fictional investor’s retirement. Pfau’s analysis backs up something I’ve believed for years: The 5 years before you retire and the 5 years afterward are the most important ones in your financial life.
And lest you think you should skip that market risk altogether, you should know that other research shows that retirees should take that risk if they want to to keep up with inflation, and Pfau found that increasing exposure to stocks improves portfolio sustainability, which typically translates into more wealth at the end of life.
Obviously, market risk plays a big role in your retirement. But you can’t predict the market and you can’t choose to go back and begin investing at an optimum time, so what can you do? To my mind, the best defense against market risk is a sell strategy. Because we use such a strategy, we feel confident that under the right circumstances, our clients can withdraw more than 1.9 percent and still have enough money to last them the rest of their lives. Given the recent market volatility, you may want to mitigate your market risk with a sell strategy, too. We’d be happy to help.