Have you been wondering how to make your money last through retirement? Dr. Wade Pfau has a recipe for retirement survival.
Dr. Wade Pfau, professor of retirement income at the American College of Financial Services and director of retirement research at McLean Asset Management, recently visited Knoxville to speak to the East Tennessee Chapter of the Financial Planning Association.
I’ve long been a follower of Dr. Pfau’s books, blog posts, and presentations. In particular, his writings on “sequence of returns risk” should be required reading for anyone about to retire, or early in retirement.
The concern is that if several years of negative returns occur at the beginning of your retirement, it could have a lasting effect on the amount of income you can withdraw from your portfolio over your lifetime. In other words, if you have to sell depressed holdings to support your cash flow needs, you are reducing the investment shares available to participate in a market recovery. (Knock on wood, market downturns have always been followed by market recoveries. If this cycle stops, we will have bigger worries!).
“The concern is that if several years of negative returns occur at the beginning of your retirement, it could have a lasting effect on the amount of income you can withdraw from your portfolio over your lifetime.”
According to Pfau, one strategy for retirement survival (among many) to reduce sequence risk is to maintain spending flexibility. As he notes, “Essentially, individuals should not expect constant spending from a volatile portfolio. Those who want upside (and, thus, accept volatility) should be flexible with their spending and should make adjustments.” This approach links retirement spending to portfolio performance. For example, a retiree would reduce spending after a portfolio decline and would increase spending based on positive performance.
Another approach to managing the sequence of returns risk is to reduce portfolio volatility. Thus, if the goal is for a constant spending level, an investment portfolio might be de-risked with bond investments, traditional pensions or income annuities that can reduce market volatility’s impact on a retiree’s income.
“Essentially, individuals should not expect constant spending from a volatile portfolio. Those who want upside (and, thus, accept volatility) should be flexible with their spending and should make adjustments.”
Dr. Pfau also writes about reducing downside risk at retirement by applying a “rising equity glide path” strategy. In effect, an investor would start retirement with a lower-than-typical stock allocation and then slowly increase the stock allocation over time.
A common way to mitigate sequence risk is to only invest in more volatile stock allocations after near-term retirement spending needs have been reserved in conservative cash and bond instruments. Perhaps covering at least three to five years of such needs. With these “buffer assets,” a retiree can avoid selling more volatile assets at a loss. Dr. Pfau appropriately notes that cash can be a drag on portfolio performance. In recent years he has focused research on the use of alternatives, such as to proactively open a line of credit with a reverse mortgage to serve as a buffer asset or even as an income source.
For new retirees, ideally, there needs to be a balance between retirement spending expectations (constant versus flexible), managing downside risk protection with upside return potential (protecting future spending) and establishing floors of financial security (cash, bonds, pensions, annuities).
Considering the various retirement income strategies and attendant trade-offs is good financial planning. To learn more about Dr. Wade Pfau’s research and writings, visit https://retirementresearcher.com.