A look into strategies for protecting your nest egg while still allowing room for long-term growth.
When you're working, a volatile market is stressful. But it's different in retirement. Suddenly, the stakes are higher. With no steady paycheck, you're relying on what you've saved - which can feel much riskier.
The market's ups and downs can be nerve-wracking when you earn income from your investments. But understanding market volatility and having a plan to deal with it is vital to keeping your retirement savings intact.
What Is Market Volatility?
Market volatility refers to the rapid movement of stock prices up or down. It's the reason your portfolio looks great one month and a little less shiny the next. While the stock market has historically trended upward over the long term, the journey isn't smooth.
These fluctuations can be more than just a blip on a screen for retirees. When you no longer add to your portfolio and instead withdraw from it, market dips can cause lasting damage.
And this risk isn't only about how much your investments grow or shrink overall - it's about when those gains and losses happen.
Understanding Sequence of Returns Risk
Sequence of returns risk is the danger that a market downturn in the early years of retirement could damage your portfolio more than one that happens later. Why? Because when you're withdrawing from your savings, any early losses mean you're selling assets at a lower price. That leaves less in your portfolio to recover when the market goes back up.
Here's an example. Imagine you retire and the stock market drops by 15% in your first year. You're still taking out money to live on, but your balance is already lower. If the market doesn't bounce back quickly, that early hit can ripple through your entire retirement, shrinking your future withdrawals.
On the other hand, if the market is strong in the early years, your portfolio has time to grow before any downturns happen. The key point? It's not just about the average return over time - it's about the order in which those returns occur.
When you're still working, market dips are frustrating, but they're not catastrophic. You have time to recover, and you're still adding to your retirement accounts. Once you retire, though, you're no longer contributing and may rely on your savings for living expenses.
In the early retirement years, your portfolio is likely at its largest. That means it has more to lose if the market performs poorly. And if you're withdrawing money simultaneously, you're locking in those losses and there's less money left to grow when the market eventually recovers. This is why the sequence of returns risk is most dangerous at the start of retirement.
Protecting Your Portfolio
The good news? There are strategies you can use to help protect your portfolio from overall volatility and sequence of returns risk. Here are a few approaches to consider:
Build a Cash Buffer
One of the simplest ways to protect against early market losses is by having a cash buffer. This means gradually setting aside one or two years' worth of living expenses in cash or cash equivalents as you approach retirement. By doing this, you won't need to sell investments during a market downturn to cover your bills. Instead, you can dip into your cash reserve and give the market time to recover.
Diversify Your Portfolio
Diversification is one of the most basic rules of investing, and it's even more important in retirement. By spreading your investments across different asset classes - stocks, bonds, and other assets - you reduce the risk of a downturn in one class affecting your entire portfolio.
If the stock market is struggling, bonds or other more stable investments can help balance things out. Of course, this approach doesn't eliminate risk (there's no avoiding that without sacrificing growth). Still, it makes it easier to weather any rough patches in a more balanced way.
Consider a Bucket Strategy
A bucket strategy involves dividing your retirement savings into three categories: short-term, medium-term, and long-term. Each bucket has a different goal, depending on when you need the money.
The bucket strategy allows you to align your retirement savings with your time horizons. A dedicated short-term bucket ensures you don't need to sell long-term investments during a market downturn. This step protects your overall portfolio from being impacted by short-term volatility. Meanwhile, your medium- and long-term buckets can remain invested in higher-risk, higher-reward assets, giving them time to recover and grow.
Not that the budget strategy is not a set-and-forget option. The short-term budget will need to be refilled from your medium-term bucket periodically. You'll then need to refill and rebalance the medium-term budget by selling assets in the long-term bucket. Then, as you approach late retirement, you may shift most assets into short- and medium-term buckets.
Delay Withdrawals During Downturns
One of the most effective ways to avoid locking in losses is by delaying withdrawals during a market downturn. If you can tighten your belt temporarily or draw from other sources of income (like a cash buffer or short-term bucket), your portfolio has more time to recover before selling any investments.
This step doesn't have to be drastic. The key is flexibility and adjusting your spending when the market takes a hit.
Consider an Income Floor
An income floor means setting up guaranteed income sources that cover your essential living expenses - think food, housing, and healthcare. This income should come from risk-free sources like Social Security, pensions, or annuities.
When you know your basics are covered, you can let your investments ride out the ups and downs of the market without panicking. You're not relying on those volatile stock returns to pay your bills.
This approach won't eliminate all your market risk, but it helps relieve some of the pressure. Then, you can afford to be a little more patient with the rest of your portfolio if the market declines.
The Deferred Annuity Option
A deferred annuity might be worth considering for those particularly concerned about the sequence of returns risk. An annuity provides guaranteed income for a certain period, regardless of what happens in the stock market.
With a deferred annuity, you invest a lump sum upfront, but the payouts don't begin until a certain age - often later in retirement. The deferral period allows your investment to grow tax-deferred over time. Once the payout phase begins, you receive a steady, predictable income stream for life (or for a set number of years, depending on the annuity terms).
However, annuities aren't for everyone. They come with fees, may not be as flexible as other investments, and aren't always adjusted for inflation. However, those looking to create a guaranteed income floor may find them an effective tool. If you're considering this option, discuss it with an independent financial professional and purchase only from highly rated companies.
Risk Tolerance and Rebalancing
Everyone handles risk differently. Some people can watch the market bounce up and down without a care in the world. Others lose sleep at the first sign of a dip.
Understanding your risk tolerance - how much risk you're comfortable with - can help guide your investment strategy. If market volatility makes you anxious, you might want to shift your portfolio toward more conservative investments, like bonds or dividend-paying stocks.
But remember, playing it too safe can have its own risks. Your purchasing power could erode over time if your investments don't grow enough to keep up with inflation.
Once you've established your risk tolerance, it's important to remember that the performance of assets in your portfolio will change over time. So, periodic rebalancing of your portfolio is crucial.
Rebalancing means adjusting your investments back to your original target mix of stocks, bonds, and other assets. Over time, your portfolio can drift - stocks might perform better than bonds, or vice versa. Without rebalancing, your risk level might be higher or lower than you intended.
When you rebalance, you sell a portion of the investments in categories that have performed well and buy more of the investments in categories that haven't performed as strongly. This practice keeps your risk level where you want it and prevents you from being too exposed to market swings.
Stay Flexible and Engaged
No plan is foolproof. Markets are unpredictable, and even the best strategies can't guarantee that everything will go smoothly. One of the most important things you can do in retirement is to remain financially flexible.
That might mean adjusting your withdrawal rate when times are tough or rebalancing your portfolio when certain investments perform better than others. It could also mean looking for alternative income streams, like part-time work or rental income. The more flexibility you build into your plan, the better prepared you'll be to handle whatever comes your way.
The Takeaway
Market volatility is a fact of life. In retirement, it can feel a little more personal when your life savings are on the line. But with the right strategies, it's not an impossible challenge.
Remember, consulting with a financial advisor can be crucial in creating a personalized withdrawal strategy - especially for those who rely on savings for most of their retirement income.
Dort Financial Credit Union is a not-for-profit financial cooperative whose mission is enriching people’s lives… members, employees, community. Unlike other financial institutions, credit union ‘profits’ are returned to the membership in the form of lower loan rates, higher dividend rates, and affordable services.
