Carmel Fisher - Timing key to adequacy of retirement savings

Some people can tell great jokes, others bungle even the funniest punch line.  It’s all in the timing.  And so it is with retirement.

If you get the timing of your retirement and your withdrawals from your retirement account right, you’ll be home and hosed.  But get the timing wrong and you could find yourself short in your later retirement years.

This is probably why as soon as they turn 60, many people put all their retirement savings into a low-risk portfolio, and then keep fingers crossed that it will last the distance.  

But a professor at The American College has taken a somewhat more scientific approach by analysing the risk of ill-timing in retirement to arrive at some solutions.

Professor Wade Plau refers to the sequence-of-returns risk to describe the phenomenon where people are more vulnerable to investment returns when their portfolios are larger, because a given percentage change has a bigger impact on their wealth.  He says the same risk exists in retirement, and perhaps even more strongly when retirees employ a fixed withdrawal strategy.    

Professor Plau completed simulations using 151 hypothetical retirees who all saved the same amount over 30 years and got 30 years worth of market returns.  But the simulations were over a 180-year timeframe, so the retirees all experienced different market returns depending on when they began and ended their retirement saving.  

On average, they built a nest-egg equal to ten times their salary, but it varied from less than three times salary to more than 27 times salary, depending on the luck of when they retired.  

Plau’s solution for mitigating sequence-of-returns risk centres on the withdrawal strategy.  First, he says, try constant, not inflation-adjusted spending.  Many people begin their retirement with a strategy of withdrawing a constant amount, adjusted for inflation, from their retirement nest-egg, say 4% a year after inflation.  The problem is, if your nest-egg is moving up and down in value, then 4% may be too much in some periods, and not enough in others.

Plau suggests considering withdrawing a constant percentage, not adjusted for inflation, which will automatically reduce when your portfolio value reduces, thereby not eating away too much at the balance.  This strategy would reduce the sequence-of-returns risk when your portfolio value is most vulnerable.  

If your retirement spending is so constant that you couldn’t tolerate such a varied withdrawal, then Plau suggests you reduce the risk of your portfolio in the early years of retirement.  Essentially he says that holding fixed-income assets to maturity will allow you to withdraw a set amount each year and know that there will be enough to see you out.  

Because sequence-of-returns risk is greatest in your earlier years of retirement, you could begin with a low-risk portfolio and a constant percentage withdrawal, then you can gradually introduce some risk assets later to allow some growth in your portfolio.  Although it seems counter intuitive to add volatility in your retirement years, it can make sense the later into retirement you are.

It turns out that the adequacy of retirement savings, like comedy, is all about timing.