As an advisor, one of the most common mistakes I see from prospective clients, is an over allocation to risk based assets. If you think about why this is, it makes sense.
The typical retiree spends their working years, automatically investing a portion of their paycheck into their 401(k) or other retirement plan. They typically put it into the best performing funds, and they see these funds compound over their working career. They do everything right, but the problem is, they fail to make a change when approaching retirement.
Leaving your retirement account in a heavy allocation to equity funds, subjects your retirement to what we in the financial industry refer to as "Sequence of Returns" risk. I try to avoid financial jargon or "fenglish" as much as possible, so I often refer to this as "luck of the draw".
For example, take Bob. Bob retired in 1990 with $500,000 saved for retirement, and needed to generate $30,000 per year in income. He left is accounts invested rather aggressively, and enjoyed nice returns over his retirement. When he passes away he’ll even leave behind a healthy inheritance to his heirs. But now let's look at Sam. Sam had the same dollar amount saved for retirement, $500,000, and needed the same income. But instead, Sam retired in the year 2000. Since Sam had bad luck when it came to timing his retirement with a bear market, Sam either needs to alter his withdrawal rate to reflect his falling account balances, or risk spending his accounts down too aggressively. If Sam doesn't alter his spending rate, Sam will more than likely run out of money during his retirement or be forced to alter his lifestyle, neither option is very appealing.
This is the luck of the draw. Most people don't want their retirement plan's success to be based on luck. To reduce this risk, this is exactly why we as advisors have to look at risk reduction strategies. Whether that’s fixed income, active management, alternatives, or income annuities, these are all tools advisors can use to reduce the risk of a major recession or lost decade ruining your retirement plan.
The general rule of thumb most retirees aim for is a 4% withdrawal rate. We were a bit aggressive with a 6% withdrawal rate in the above example, and even a 4% withdrawal rate may be difficult to sustain over the next few decades.
The US Equity markets are entering somewhat uncharted waters, with interest rates beginning to rise while equities are nearing their highs. The 4% withdrawal rule is built specifically for a retiree with a thirty year time span. What about someone retiring in their 50s? They could easily see a 40+ year retirement. The 4% rule also uses historical data of the US markets going back about 90 years. Correct me if I'm wrong, but the United States has done quite well over that time period, and we may not sustain a similar growth pattern.
Now, I'm not trying to say the 4% rule won't work, or that you shouldn't have equities in your portfolio. The point of this article is to remind retirees and pre-retirees to exercise caution when it comes to over allocating to equities and generating retirement income, because you don’t want your retirement plan to be based on luck.
Richard W. Paul is the president of Richard Paul & Associates, LLC and the author of “The Baby Boomers' Retirement Survival Guide: How to Navigate Through the Turbulent Times Ahead.” He is a Certified Financial PlannerTM professional, Registered Financial Consultant, Investment Adviser Representative and an insurance professional holding life and health insurance licenses in Michigan and Florida.
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