For most of us, investing is all about saving money and building as much wealth as we can while we’re still working. But for many investors, the biggest decisions we’ll make in our financial lives come when we finally make the move from accumulating assets, to turning those assets into a steady stream of income that will (hopefully!) last us comfortably throughout our retirement.
When we’re working and saving, our financial goals are often as simple as getting the highest rate of return on our investments. Market fluctuations don’t matter all that much, because any reliably diversified long-term plan will take market ups and downs into account, and use the down years as an opportunity to purchase more assets at a discount.
But once you retire, even something as reliable as a broadly diversified basket of stocks needs to be managed a little more carefully. Short-term market fluctuations don’t matter much when you still have plenty of time to recoup your losses or earn more money. But they matter a lot when you’re relying on your investment portfolio for income, and no longer have the option of adding new capital to the mix.
The biggest risk most investors face in retirement is the prospect of a series of bad market years right when you decide to hang up the suit for good. If all your money is in the market, even a handful of down years in a row could spell disaster, especially if you’re relying on your portfolio for income. In financial planning terms, we call this “sequencing risk.” But what it really translates into is simply bad timing.
When you’re in your 30s or 40s, for example, a case of bad timing doesn’t really matter. If you were 30 when the market drops of 2008 and 2009 occurred, as long as you didn’t panic and continued to invest as usual, those down years would’ve actually turned into a significant long-term advantage. Whatever money you added to your portfolio during that time got put into the markets while they were down 40 per cent or 50 per cent, so the subsequent recovery would’ve likely supercharged your overall returns.
But if you had just retired in the spring of 2008 and were expecting to start withdrawing a fixed amount from your portfolio as income, those down years would’ve had a doubly negative impact on your investments. With the markets down 50 per cent, you would’ve had to sell twice as many shares to realize the same amount of income. Even after stocks rebounded, those extra shares you had to sell would be gone forever, causing permanent damage to your portfolio and possibly derailing your entire retirement plan.
Of course, there are some people who simply don’t experience any sequencing risk. People with defined benefit pension plans, for instance, or those lucky few who have so many assets that nothing can make a meaningful dent in their standard of living. But for the rest of us who are counting on redeeming a percentage of our portfolios for income each year after we retire, sequencing risk is something that needs to be consciously managed both before and throughout our retirement years.
A generation or two ago, sequencing risk was barely even a minor consideration. Most folks had solid company pensions, and the average retirement only lasted for 10 or 15 years anyway. Investors could just put all their hard-earned life savings into something that wouldn’t fluctuate, like government bonds or GICs, and the effects of inflation over just a decade or so were usually pretty minor.
Today, however, retirement for most of us is likely to look very different. The average retirement these days will probably last for 30 years or longer. With bonds and GICs yielding next to nothing, after 30 years of inflation, a completely no-growth strategy probably means you’ll end up running out of money.
To deal with the dual dangers of sequencing risk and inflation, I advise my retirement-age clients to keep most of their portfolios in stocks and other growth assets, while making sure they set aside a large enough sum in investments that won’t fluctuate to cover their income needs if they get hit with a few years of market turbulence. This usually means starting to build out a fixed income portfolio several years before they retire, and then having a plan in place to keep that portion of their investments at the right level throughout the years when they will be drawing income.
So what is the right amount? As usual, the exact percentage will vary by investor depending on how much income you need to sustain, your overall rate of return, and how much long-term growth you still need to get from your portfolio after you retire.
But whatever portion of your portfolio you keep in stocks, you need to plan for the inevitable market drops that will occur about once every five years. The longest continuous market correction we’ve experienced since the Second World War lasted for about three years, so setting aside a minimum of three years’ worth of income in a safe investment harbour is a pretty good starting point.
Perhaps the biggest change is in how we manage our own behaviour. Human beings tend to get greedy when times are good and timid when times are bad. For people who are retired or looking to retire soon, a great run on tech stocks should be a signal to cash some out and build up a reserve, not a sign to double-down and let it all ride on the next roll of the dice. Similarly, market corrections are the time to consider putting some of the reserve you set aside back into stocks, to take advantage of the inevitable rebound when it occurs.
All too often, fear and greed drive people to do the reverse. They pile into the market when it’s up, and retreat to cash or bonds when it’s down. But for those who are in or close to retirement, having a plan in place to manage your sequencing risk by adding to fixed income investments in good times and buying stocks when things go south is the single best tool you have to help make sure your income lasts for as long as you need it to.
This article is supplied by Alan MacDonald, an investment advisor with RBC Dominion Securities Inc. Member–Canadian Investor Protection Fund.
