Why Your Retirement Plan Will Fail: Part Two
Unfortunately, most articles out in the media today focus on a few financial topics; reducing spending/budgeting, paying down debt, buying a house and investing in low cost index funds. While all these topics are important there is one aspect of financial planning that is rarely discussed; describing what retirement is actually like.
Over the next month or so, we are going to take a deep dive into describing retirement from a financial perspective. We are going to look at what risks can derail a retirement and how to create a plan to mitigate those risks. Part two will focus on a more common or obvious retirement risk: Market Risk.
Social Security typically covers only a portion of an average American’s retirement expenses. Americans are responsible for funding their own retirement (Pensions, you had a nice run) and the main retirement vehicle is the 401k plan. Investing in 401k plans means investing in equities (stocks, bonds, mutual funds, ETFs, etc.) which in turn can add a layer of risk to a person’s retirement plans.
Let’s look at the S&P 500 over the last 20 years:
As this chart from JP Morgan shows, the S&P 500 Index (Which is a collection of the 500 largest US companies) has three periods of growth over the last twenty years: from ’97-’00, ’02-’08, and ’09-today and two bear markets (which is defined as a market correction of 20% or more). As a retiree, the thought of losing 49% or 57% of your retirement balance would be unbearable. Since most retirements are lasting twenty years or more, retirees should expect to see several market fluctuations over the course of their retirement. On average, 5% market corrections occur every 10 weeks, 10% corrections occur every 33 weeks and 20% corrections occur every 127 weeks*.
How Can Losses Impact a Retiree?
If a person is still in their accumulation phase and not yet retired, a 20% loss can be recovered in three years with a positive total return of 25%. As long as there is enough time, a loss can be recovered for someone that is not yet retired. If we take that same scenario and we use a retiree that is withdrawing 4% of their funds annually, it would take a total cumulative return of 42% just to get back to even. Basically, the retiree would have to average 14% per year for three years just to get back to where they started. Earning 14% per year is not a likely scenario for any retiree.
As a result, most retirees look to reduce the risk in their portfolios by shifting their money away from equities and into “safer” investments such as fixed income (bonds). Moving assets from equities to fixed income or cash will help reduce the impacts of market risk, but it will minimize the overall long-term performance of the retirement portfolio. Having a portfolio that is too conservative means the retiree will miss out on some or most of the market recovery. Trying to time the market is an even worse strategy.
What Can a Retiree Do?
From a mental standpoint, a retiree must accept that market corrections will happen. With that in mind, there a couple of things a retiree can do to mitigate the market risk. Frist, they can invest in assets that are not correlated (doesn’t move in the same direction) to the market. An example would be cash value life insurance. Cash value life insurance policies can act as a bond alternative and can provide a consistent rate of return each year. Second, a retiree can look at investing a portion of their portfolio into annuities. Annuities can offer a consistent stream of income for the rest of a retiree’s life regardless of what happens in the market. Third, a retiree can look to bucket their investments into three time frames; short-term, mid-term and long-term. Having a short-term investment allocation will give the retiree a “safe” place for their money to weather a market correction. The mid and long-term buckets will give the portfolio the ability to take on more risk and therefore potentially earn more over time.
*Source: Ned Davis Research, Northern Trust, S&P and Alliance Bernstein