Description of order of return risk

If you’re less than 10 years from retirement, the current stock market volatility may be a reminder of the important risks awaiting your nest egg.

Stocks tend to offer the best opportunities for long-term growth despite their ups and downs, but if you need to leverage those assets when prices are falling, you may run into problems as markets continue to slump as you head into retirement. Mike Casey, founder and president of AE Advisors in Alexandria, Virginia, and a certified financial planner, says this can permanently shorten the lifespan of your portfolio.

This happens “by forcing investors to sell distressed assets, reducing the capital base available for recovery,” Casey said.

This problem is known as “order of profits” risk. This essentially means that the sequence or sequence of gains or losses over time is important when liquidating investments.

“The best way to deal with a range of return risks is to plan before someone retires,” said CFP Andre Small, founder of A Small Investment in Houston. “I typically encourage clients to begin planning for sequence risk at least three to five years before retirement.”

Since the Iran war began on February 28, major stock indexes have been on a downward trajectory due to soaring oil prices, concerns about inflation, and uncertainty about when the conflict in the Middle East will end. From the beginning of the year until Thursday Standard & Poor’s 500 Index The index, a broad measure of how U.S. companies are doing, fell by about 4%. of Dow Jones Industrial Average It fell 3.1% for the year, with high-tech industries leading the charge. Nasdaq Composite Index It fell about 7%.

But last year the S&P rose more than 17%, the Dow rose about 13% and the Nasdaq rose 19.8%. It’s impossible to predict what the stock market will do in the future, but volatility is to be expected.

For long-term savers, people whose retirement is years or decades away, the ups and downs of the stock market are generally less important because their portfolios have time to recover before becoming a source of income. For these investors, “the sequence of return risks…isn’t that big of a deal,” said Frank Maltais, CFP, a financial advisor at Fidelity Investments in Portland, Maine.

But for newly retired people, it can make a big difference, Maltais says.

“If you retire in a poor market, your nest egg may dwindle over time, especially if you don’t scale back your withdrawals while that market is in decline,” Maltais said. “On the other hand, having a strong market early in retirement can create headwinds.”

For example, a recent report from Fidelity found that if a retiree starts with a balance of $1 million and withdraws $50,000 each year, followed by a period of positive returns in early retirement followed by a bear market, the portfolio balance will exceed $3 million after 30 years. On the other hand, if you retire early and have a negative return followed by a bull market, your portfolio will be depleted in 27 years.

Maltais said withdrawal rate is an important component of sequence risk.

He cited the early 1970s as an example. If a 65-year-old retired around 1972, just beyond that was the bear market of 1973-1974, when the S&P fell 48%. “At that time, inflation was very high, there was an oil crisis, there was a lot of political instability,” Maltais said.

“An investor who had a balanced portfolio with a variety of asset classes such as stocks, bonds and cash and was making a 4% return might have thought that their portfolio would last,” he said.

But those who have had to withdraw are at higher risk of depletion, and the higher the withdrawal rate, the earlier the age at which their portfolios are depleted, he said.

Advisers say it’s important to not only understand your sources of income (Social Security, pensions, pensions, part-time jobs, etc.), but also to understand what your expenses will be in retirement. This will help you determine how much of your portfolio you should use in a given year.

“To start mitigating this (ordering) risk, the most important thing to start with is understanding your spending needs, rather than just starting with portfolio allocation,” said Matthew McKay, CFP, investment director at Bryau Financial Advisors in College Station, Texas.

“The reason we start there is to understand what level of cushion you need to build into your (asset) allocation,” McKay said.

“Once you have that number, build a base of income-oriented assets that are intended to be used for initial expenditures. This will ensure you have time to see how the market is doing and perhaps recover if it goes down, and you don’t have to sell on weakness,” he said.

Maltais said withdrawal rates can affect how much of a portfolio should be in stocks. For example, someone with sufficient other sources of income might expect to only need 1% of their annual portfolio. He said that investor may be able to afford to invest more aggressively than one who expects to need 6%.

One way to plan for risk is to have a solid emergency fund, Maltais says.

“Try to have one to two years’ worth of expenses in cash,” he says. “That way, if there is an unexpected economic downturn,[retirees]won’t necessarily have to sell as much of their portfolio when unexpected expenses occur.”