Sequence of Returns is the danger that the timing of withdrawals from a retirement account will have a negative impact on the overall rate of return available to the investor. Account withdrawals during a bear market are more costly than the same withdrawals in a bull market.
One of the biggest risks for retirees who want to generate their retirement income from a volatile investment portfolio is large negative returns early in retirement. We often call this sequence of returns risk. When you withdraw money from an investment portfolio, negative returns early in retirement can cause the portfolio to fail faster than if those same negative returns instead occurred later in retirement. This is especially true for those in the first few years of their retirement.
To address worries about running out of money in retirement, your financial advisor or financial planner may prepare investment plans and income projections showing how your portfolio is sustaining your investment income. Here are a seven methods your financial advisor may be recommending to managing the sequence of returns risk.
- Diversify your portfolio. Diversification means re-balancing to include fixed income or alternative products in addition to quality stocks, including a mix of investment approaches, company sizes, and geographic exposures. We have seen that a diverse portfolio experiences less volatility that comparable markets.
- Use Monthly Income solutions. Many fund companies offer produces designed to provide monthly income to address the sequence of returns issue. The monthly income may be in the form of dividends, interest, or return of capital. You may use a T-series fund, for example, to get very tax-efficient monthly income. These solutions are designed to provide a sustainable income source. Some investors may choose to suspend their withdrawals during market volatility to preserve their portfolio. Other investors choose to take their dividends in cash so that they may make withdrawals without selling holdiings.
- Change Timing of Withdrawals. Some investors have switched from monthly income to annual income, with a plan to make their RIF withdrawal in December, should markets be stronger at that time. In addition, deferring the RIF withdrawal can allow you to take advantabe of the reduced RIF minimum withdrawal for 2020.
- Limit Withdrawal Rate. A rule of thumb is to withdraw 4% of capital. Historically, the 4% distribution of the initial account value adjusted for inflation could be maintained for 30 years. This 4% rule seeks to provide a steady income stream to the retiree while also maintaining an account balance that keeps income flowing through retirement.
- Tapping into home equity. Using a home equity line of credit during a market downturn can help provide needed cash flow to meet spending needs in retirement in lieu of selling investments during a down year. It can allow you to afford to limit your withdrawals from your portfolio. This strategy is usually seen as a short-term solution for those comfortable with the risk of debt and with the recovery of the markets.
- Income Laddering. A popular strategy to manage sequence of returns risk is to create income from non-market sources. Creating a ladder of bonds or GIC's with one maturing each year, can provide cash flow and a more secure income than the market can provide. It also allows you to leave market-based investments invested for their eventual recovery.
- Cash Wedge. A cash reserve bucketing strategy became a popular means of funding retirement income in past times of market volatility. With the bucketing approach to address sequence of return risk, you separate assets into buckets of money for different time periods. You hold cash or an investment savings account for short-term needs, balanced solutions for the mid-term period and equities for the long term. Some people decide to hold one to two years of cash in order to meet short-term spending needs in retirement. If the market sees a big downturn, they can then spend their cash for two years to ride part of the downturn and allow their equity investments to recover.
Retirement income planning must be done with your goals and risk tolerance levels in clear focus. Because retirement income planning can be complex and requires monitoring over time, it can be helpful to find a financial professional who specializes in comprehensive retirement income planning to help develop, carry out and monitor a retirement income plan.
As always, speak to your advisor to discuss the ideas that are appropriate to you and your situation. Our joint advisor team is available by phone, email, and video-chat. It's another way that we are here for you.
- Elaine Kelly, MBA CFP, FCSI, Senior Investment Advisor, Manulife Securities Incorporated
- David Wyatt, BA, B.Comm, CFP, Investment Advisor, Manulife Securities Incorporated
- Katlin Wyatt, BA, Investment Advisor, Manulife Securities Incorporated
- Diana Kancko, Executive Assistant, Manulife Securities Incorporated
- Terry Wyatt, Executive Assistant, Manulife Securities Incorporated