Is Now The Worst Time To Retire?

A closer looks at a recent claim made in Barron's

I saw the following ad from Barron's, note the quote at the top;

With equity markets very close to all time highs, the typical investment portfolio with an allocation to equities is likely also close to all time highs so what's the deal? If someone's got more money than they've ever had and it is just about the right time for them to retire then now would seem to be a great time to retire.

The quote of course pertains to sequence of returns which we have explored here before. Sequence of returns refers to just that, the sequence of returns that you get over some period of time and for this post the assumption is that you'll likely be close to the the market one way or another. So if over the next three years the market averages a gain of 8% annualized you'll get something like 6%-10% annualized. The relevance to the Barron's ad is to raise the possibility that a bear market is soon to start and could derail the plans for someone planning to retire at the end of the year for example.

As an example, someone who believes they need $900,000 to retire the way they want to, intending to do so at the end of the year could very easily make it work with just $870,000. Where sequence of returns hits hardest, adverse sequence of returns, that with the above scenario some sort of severe down draft takes a huge bite out of a 60/40 asset allocation.

At $870,000 with a 60/40 split, this person would have $522,000 in equities and $247,000 in fixed income. If the equity market fell 40% then the formerly $870,000 portfolio might only be worth $560,000. Thinking in terms of a 4% withdrawal rate, this person may have been planning on taking out $34,800. Either they are taking that amount which is actually now a 6.2% withdrawal which is a big bite in year one or two of a retirement or they are going to stick to 4% which means only withdrawing $22,400 which is a big difference in lifestyle. The $560,000 now less the first withdrawal of $28,000 (they split the middle) leaves them with $532,000. And what if in the same year they have a transmission emergency that costs $3000 and a roof problem that costs $6000. Now, 18 months in they are down from $870,000 to $523,000. How much are they going to take out in their second year?

A normal stock market cycle and the avoidance of panicking can bail this situation at least partially out over time but there are no guarantees of the cycle bailing you out and even if it does, at the very least this scenario amounts to a nerve wracking few years. Or perhaps the bear market starts a few months or a year before the planned retirement date and the person decides to delay their retirement. The could trigger all sorts of negative quality of life issues.

There are several ways to mitigate this adverse sequence of returns for anyone who thinks they are close to retirement. One is to simply go to cash right now in a meaningful way. Yes, you'd be giving up potential further gains but if you have $870,000 with a goal of $900,000 you'd know what you have and like I said above, most people can make those numbers work.

Another way to mitigate this outcome is to set aside some number of month/years worth of expected living expenses in something that won't go down in value like cash or Treasury Bills. In doing this, I would not draw from this bucket of money until the equity market was down a lot. Someone worried about a decline who turns out to be wrong, or just early, will then be ready for whenever that big decline inevitably comes. How much should someone set aside? You will get differing opinions but this is different than a six month, out of work fund. I would think of this in terms of how long bear markets usually last which is usually something like 18-30 months, so that many months in expected expenses is how I would lean. Not total expenses as Social Security will of course still pay in a bear market, I mean the amount to fill the gap between total expenses and SS payout.

The third idea is to actively manage this in the portfolio with some sort of defensive strategy or using one/several of the ETFs that take defensive action one way or another for you. Examples of this type of ETF include client holding Pacer Trend Pilot Large Cap ETF (PTLC) and WisdomTree Dynamic Long/Short US Equity Fund (DYLS).

Being more hands on, heeding a breach of the S&P 500 Index versus its 200 day moving average or other similar catalyst could also be effective in mitigating adverse sequence of returns. None of these will be perfect but they don't have to be. If, in enduring a bear market in year one or two of retirement you take no money out of the investment portfolio (by virtue of the first option) or you only drop to $750,000 (from the $870,000 starting point) instead of $523,000 by virtue of effective defensive action then that would be a huge win.

I would stress there can be no guarantees but the first step is being aware of the threat posed by an adverse sequence of returns and then devising a plan that you can stick to in order to try to avoid the full blow of an adverse sequence.

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