Why Is It So Important To Reduce Risk After Retirement?
- The stock market is one of the best placed for younger investors to invest their retirement savings.
- After retirement though, once you enter the withdrawal phase of your life, you should reduce your overall portfolio risk.
The stock market is one of the best places to invest for the long term. Stocks are also one of the best places to invest retirement savings, simply because retirement tends to be a longer-term strategy. But, as we all know, the stock market can also be a risky place to put your money. In fact, stock markets in the United States have fallen by greater than 50% twice, just in the last 20 years!
For younger investors, I wouldn’t worry about 50% losses. Markets recover over time, yielding great returns to those who are patient and willing to wait out short term declines.
For those who are retired, though, you need to take a different approach. Established financial planning theory states that risk should be reduced dramatically after retirement. But, with fixed interest rates at historic lows right now (2019), I see more and more retirees convincing themselves that they are still long-term investors and should continue to leave their retirement funds in high risk strategies.
There are two reasons retirees need to reduce the risk they are taking within their portfolios.
1) Timing Your Recovery
One of the main reasons financial planners recommend lower risk to retirees is simply the fact that they don’t have as much time to wait out a short-term market decline.
It’s simple math. Let’s say you reach your required savings goal of $500,000 and decide to retire. The first year of your retirement happens to coincide with a year 2000 or year 2008 type of market crash of 50%. You’re down to $250,000. How much do you need to break even?
The easy answer is, if I’m down 50%, then when the market recovers by 50%, I’m back where I started. But that’s not how it works. A 50% recovery would only bring your $250,000 back up to $375,000. In fact, at 50% decline requires a return of 100% to break even! At 60% decline requires a 150% return to break even! A 1930’s type 80% decline requires a 400% return just to break even!
Small losses hurt you more than large gains help you. This is fine for younger investors, since long term market averages still make the risk of the market worth taking. But how long would it take to make back 100%? If you are close to retirement, are you willing to delay retirement for a decade or more, waiting for the recovery? If you are already retired, are you willing to go back to work for 10 years until the market recovers?
2) Sequence Of Returns
Here’s an even more important reason to reduce risk after retirement. There are two phases to retirement planning. The accumulation phase is when you are contributing toward your savings goal. This is when you want to take risk.
After retirement, you enter the withdrawal phase, when you are drawing down your savings every year. This is when you want to reduce risk.
Look at the left column of the chart below. Let’s say you retire with $500,000 in savings, and you continue to invest in an aggressive portfolio. Over the first 10 years, you get returns of 19%, 26%, 23%, 12%, 7%, 11%, 9%, -22%, 19%, -13%. Just two relatively small losses compared to the gains achieved. Your average rate of return is 8%.
During retirement, though, you are withdrawing funds from your account at an increasing rate. $50,000 in the first year, increasing by 2% per year to offset inflation, so in the second year your withdrawal is $51,000, and it increases to $59,755 by the 10th year.
Look at the account balance. In the 10th year, you still have $423,045 and you’ve withdrawn $547,486!
Here’s the catch. The losses, as small as they were, were incurred late in the 10-year period. But market timing is historically impossible. As a long-term aggressive investor, you know you are going to incur some losses, but when you are in the withdrawal phase, the timing of those losses makes all the difference.
The right column reverses the returns, placing losses in year 1 and 3. The average return is the same 8%. But, because the losses were incurred early in the 10-year period, you’ll run out of money in year 10!
Think about it! The same average rate of return and in one case you have over $423,000 left over, and in the other case you have $0.
You don’t want luck and timing to determine your success in retirement. If you are in the withdrawal phase of your live, you absolutely want to reduce the amount of risk you are taking, even if it means accepting relatively low returns.