- Although stocks were climbing higher on Tuesday after dropping on Monday, there's persistent uncertainty among investors over whether a bigger pullback is coming.
- If you're about to retire or recently have done so, it's worth gauging how a prolonged market downturn would impact your retirement plan.
- This is due to what's called "sequence of returns" risk, although there are options for reducing its impact on your portfolio.
New retirees — or anyone on the verge of retiring — may want to consider what an extended stock market dip would mean for their portfolio over the long term.
While the market has partially rebounded from Monday's slide, it's a good reminder that down markets can pose significant "sequence of returns" risk in the early years of retirement. That risk basically is about how the order, or sequence, of stock returns over time — combined with your portfolio withdrawals — can impact your balance down the road.
"If there's a downturn early on, it can derail a whole retirement plan," said Wade Pfau, a professor of retirement income at the American College of Financial Services.
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The Dow Jones Industrial Average shed 1.8% on Monday, while the S&P 500 Index dropped 1.7% and the Nasdaq Composite index lost 2.2%. Although stocks climbed a bit on Tuesday, there's persistent uncertainty among investors over whether a bigger pullback is on the horizon.
For long-term savers — those whose retirement is many years or decades away — such market drops matter less because there's time for their portfolios to recover before they need to start relying on that money for cash flow.
The stakes are higher in retirement.
"If there's a big loss in the market and you're taking withdrawals, you could be taking more from your portfolio than what it can make up for," said certified financial planner Avani Ramnani, managing director at Francis Financial in New York.
"If that happens early in retirement ... the recovery may be very weak and put you in danger of not recovering at all or being lower than where you would have been and therefore jeopardizing your retirement lifestyle," Ramnani said.
To illustrate how sequence of returns risk can impact your savings: Say a person had retired at the turn of the century with $1 million invested in the S&P 500 and withdrew $40,000 each year, with withdrawals after the first year adjusted 2% for inflation.
In 2020, the remaining balance would have been about $470,000, according to Ben Carlson, director of institutional asset management for Ritholtz Wealth Management, who crunched the numbers for a blog post.
In the above scenario, the portfolio would have been subject to a bear market at the outset of the person's retirement, when the S&P lost 37% over three years, 2000-2002, but enjoyed a long-running bull market that began in 2009.
However, if the order of yearly returns were flipped — the gains posted by the S&P at the end of the 20 years happened first and that early bear market happened last — that same person would have more than $2.3 million after withdrawing the $40,000 or inflation-adjusted amount each year.
"It's not the specific returns over time but the order of those returns that matter," Pfau said.
How to combat the risk
The good news is that there are options for mitigating the risk.
The first is to simply plan to spend more conservatively, Pfau said. In other words, the less you spend consistently, the less you have to withdraw overall.
Another strategy is to adjust your spending when your portfolio performance is suffering.
"You look at your expenses and see if there are any you can stop," said Ramnani. "So maybe you don't take a trip, or you delay doing a large renovation that would require a big distribution."
You also can actively reduce risk in your portfolio, Pfau said. For instance, you could have a low stock allocation early in retirement but increase it over time, or use bonds for short-term expenses and stocks for long-term ones.
"You're strategically reducing volatility," Pfau said.
The last option is to have assets outside your investment portfolio that can support your spending needs when stocks are underperforming.
"You would use that as a temporary resource while you wait for your portfolio to recover," Pfau said.
He said that buffer could be cash, a reverse mortgage line of credit or permanent life insurance with a cash value, assuming it's protected from market losses.
Additionally, given how well the market has generally performed over the last decade, you may simply be able to meet your goals without taking on the risk that comes with stocks.
"You could take some of that volatility off the table," Pfau said.