It’s been a wild ride in investment markets thanks to the tariff war. While this needn’t be of concern to long term investors, it’s every new retiree’s nightmare. Just as you get to the point of giving up work and setting off to travel the world, investment markets crash. Taking the plunge to head into retirement is scary enough without markets collapsing just at the wrong time.
Leading up to retirement, the focus is on saving and accumulating wealth. In that stage of life, market volatility is more of an opportunity than a threat. There is still time for markets to recover. Regular contributions into KiwiSaver and other investments when markets are moving up and down produce an effect called ‘dollar cost averaging’. This simply means that when you are contributing a regular fixed dollar amount, you will buy more units when prices are low and fewer units when prices are high. Over time, the price paid per unit is as close to average as possible. A market crash is favourable for long term regular contributors, as it allows investors to buy more units for the same amount of money. Over time, the value of these units will rise again, so the investor achieves a good return in the long run.
However, the effect of a market crash on retirees wanting to make regular withdrawals has the opposite effect. When you are taking income from your investment portfolio, you are selling units regularly, not buying. You need to have a plan in place to make sure you aren’t forced to sell investment units when prices are down. This type of investment risk is called ‘sequencing risk’. Sequencing risk occurs when you regularly withdraw amounts from your portfolio. Here’s how it works.
Investment returns go up and down from one year to the next. Over a ten-year period, a portfolio left intact with no withdrawals might produce a return of, say, 7% a year on average. However, in any one year the returns might vary between losses and gains – for example, between a loss of 12% and a gain of 18%. If there are withdrawals made from the portfolio at the start of the ten-year period and there are losses at that time, it is much harder for the portfolio to recover and the return will be much less than 7% over ten years.
Retirees are much more exposed to sequencing risk in the early years of retirement. A crash in the early years when large withdrawals are being made will have a lasting effect on the performance of an investment portfolio. Typically, new retirees have a bucket list of things they want to do after leaving work, and travel is high on the list. Other ‘big ticket’ items for early retirement might be replacing the car and renovating the house. It is therefore not unusual for spending and portfolio withdrawals to be higher in the early years of retirement.
However, there are steps that can be taken to protect yourself from sequencing risk.
Plan for a lower return. When you are making plans for how much you can withdraw over your retirement from your investment portfolio, use a conservative estimate for the rate of return. It’s preferable to have money unspent that to run out of money before you die.
Use a laddered portfolio of bonds or term deposits. In the last few years before retirement, build up a stash of cash which is invested in stable assets such as cash and bonds. Have enough on hand at retirement to cover your spending needs for at least the first five years. Set these investments up so they mature at regular intervals – say every six months. That way, you will have cash on hand when you need it and the rest of your investments can be left untouched in a diversified portfolio to recover from any fall in share prices. When your bonds and term deposits are used up at the end of five years or so, make a withdrawal from your diversified portfolio and set up a new portfolio of bonds and term deposits to last the next five years.
Get advice on a ‘safe’ withdrawal rate for your portfolio. The big fear for anyone over the age of sixty is whether they will outlive the money they have saved for retirement and end life in poverty. Working out how much to safely withdraw from your portfolio on a regular basis is not easy as there are so many unknowns and a multitude of theories on the best approach. The challenge is to withdraw neither too much nor too little while also being aware of sequencing risk.
