This 1 Risk Could Derail Your Retirement - Sequence of Return RiskRetirement Funding
Today I want to talk about the one risk that's rarely talked about, but really could derail your retirement if it's not managed effectively. But first I want to introduce myself. My name is Warren Burger. I'm the owner of Luminary Financial Advisors, and we help people that are nearing retirement or recently retired, create and implement a retirement plan really with an emphasis on saving money on taxes. The retirement risk that I'm talking about is called sequence of return risks. And this refers to the idea that the timing and sequence of poor returns in your portfolio could ultimately have a lasting impact on how long your portfolio will last in retirement. It means that if you start taking money out of your retirement investments at a time when you have a market downturn, you're going to be depleting some of those assets and looking for returns over time. But now you're starting with a lower base, so it actually will decrease the potential amount that you have at the end of your retirement.
So you can have two retirement accounts that, let's just say they had an average investment return of 8% over a 20 year period, The retirement account that started out with lower returns and maybe had higher returns. So that average ended up coming back to 8% will end up having a lesser value at the end of 20 years than a portfolio that had stable returns at the beginning of that period and then had a downturn later on. I'm sure you're asking how do we mitigate these risks? And so there, I'm going to give a couple of examples today, and there's a number of ways to do this, but I think the broader point that I want to make is that you need to be thinking about this well before you get into retirement. If you're in retirement and now you're starting to deal with the sequence of return risk, it's likely going to be, it's not necessarily too late, it's just going to be more difficult to be able to manage.
So let me go through a couple of examples of ways that you can mitigate this. The first one is to use a dynamic spending strategy when it comes to utilizing your retirement assets. This just means that you're going to adjust your spending when you're seeing large fluctuations in the market, especially at the beginning of your retirement. One approach to dynamic spending is utilizing a guardrail strategy. A guardrail strategy is basically set up to say that if you start with a certain percentage that you're taking from your retirement portfolio, if there's a fluctuation in that percentage within a certain amount, you're going to adjust your spending. So let's take an example. Let's just say that you have a million dollar portfolio and you've decided that you're going to take 5% of that portfolio each year for your spending needs. In this case, that would be $50,000 of the 1 million portfolio. If that 5% was to move within 20%, either way, you're going to make an adjustment to your spending. So in this example, let's just say that that $1 million portfolio now had gone down, there was a market downturn, and now that $1 million portfolio is now worth 833,000. And that's
Exactly the number that would put your 5% withdrawal rate now would be at 6%. You're now taking out more of that lesser amount based on a percentage terms. So once we see that 20% raising a 5% to 6%, which is 20%, we would decrease your spending by a 10%. So in this case, that $50,000 a year would go down to $45,000 a year, and we could, that dynamic spending means that if markets come back up again within a certain period of time, we can raise that spending. And just like you had throughout your life factors change, you might have lost a job at some point, you might have had increased expenses for something and you made adjustments to your spending. This is all we're going to do in retirement as well. So there's a converse to that where you can actually get yourself a raise. Let's just say that 1 million portfolio went up to 1.25 million.
Well, that 1.25 million would be equivalent of a 4%. So now we've had a 20% adjustment down in terms of now you're taking 20% less of your portfolio, so we can give you a raise of 10%. So in this case, that $50,000 would be a $55,000 per year. And so we can just keep doing these adjustments throughout your retirement, thereby mitigating that sequence of return risk that can happen at the beginning of your retirement. So a second strategy that you can use is called a bucket strategy. And we use this really use this for most of our clients. And what this says is that we're going to have a war chest of cash and bonds for a certain period of time throughout your retirement so that we don't have to feel the effects of markets going up and down as quickly. And let me give you an example of that.
So for our clients, generally what we do is we figure out what your expected expenses are going to be in a given year. Generally, those are going to be pretty close. You're including vacation monies and things like that. Obviously things will pop up and we make arrangements for that as well. But what we would do is we'd figure out those two years of expenses and we'd keep two years of your assets in cash. That means we have readily liquid funds available for a total of two years. Now the next three years, we would keep in fixed income or bonds. Now, bonds don't move as they're not as volatile as stocks, which means you're not going to make as much money on bonds, but you generally tend to have them fluctuate to the downside that much less as well. And so they're a little bit more secure. And so we're looking at combining that two years of cash with that three years of bonds to really give you five years of a cushion if there was to be a market downturn before the rest of your assets, which are now going to be in stocks, have a time to come back.
So this can be a really useful way for people to feel like when their market downturns like we're having
Here in 2022 to feel like, Hey, we have a certain amount of insulation here because we don't even have to worry about markets coming back really for a total of five years. Now, this is just another example of a way to mitigate that sequence of return risk, so that if you were to have a downturn in the markets at the beginning of your retirement you would have that cash cushion, that war chest to protect you. But here's the thing, You have to set up that war chest well before that you're starting to retire, right? You're you, you're going to want to, at the point of retirement, have five years of that cash and bonds in place, which means it takes a bit of preparation, usually two to three to five years before you're retiring. You want to start to put these things into place. You might want to check out some of the other videos I have here that goes a little bit deeper into each of these withdrawal strategies.
But ultimately, I just want you to have in your head that as you get closer to retirement, there's more to think about than just social security Medicare taxes. You really want to think about how your investments are going to be structured so that they'll last throughout your retirement. I hope this has been helpful for you. If you look in the comments section down below, I have some links available to some checklists and flow charts that I think are really helpful as you approach retirement. And if you'd like to have a complimentary call about your personal financial situation, I also have a link there to my personal calendar. Feel free to schedule a chat on a day and time that works for you, and hopefully we can help you with your financial situation as well. Thanks, and I can't wait to see you again on our next video.