When mapping out retirement income, you need to first look at where you’re putting money and why.
Many approaching retirement follow the traditional advice of contributing to a “qualified retirement plan” such as a 401(k), a 403(b), a simplified employee pension (SEP), or a profit-sharing plan, depending on their work status. People do this mainly so they can deposit maximum funds into these accounts.
For those under the age of 50, most financial websites state the following: “If you are not saving to the max in your workplace savings plan today, consider increasing your contribution in 2015 to the IRS limit of $18,000 to help reach your retirement savings goals.” Those over the age of 50 can add $6,000 above that limit, for a total of $24,000 per year. For SEPs or profit-sharing plans, upward of $52,000 can be contributed for 2015.
These statements have little to do with helping anyone understand the various risks—sequence of returns, tax, market, inflationary, or longevity—in retirement. They just focus pre-retirees on putting more money into the market and qualified retirement accounts.
One of the more acute risks that pre-retirees should contemplate is sequence of returns, or the effect of low or negative returns on an account and how they diminish the value of a portfolio’s ability to produce a sustainable income during retirement. A little-known fact about sequence of returns is that, during the accumulation phase, it has no bearing on the order—the result is the same.
Often pre-retirees take this risk for granted, relying on one simple premise: the market will always rebound if you wait long enough. If we look at the history of the majority of portfolios, most will take upward of 10 years to recover from a single year of loss.
For example, imagine a person whose income is under $275,000. They are in a 35% marginal tax bracket, along with getting an 8.5% rate of return. They make contributions of $52,000 per year until age 59, and then takes income at age 65 from the plan. Keep in mind that if we were to run the numbers based on maximum funding of a 401(k) at $24,000 per year. The results would be the same with a smaller portfolio.1
When we run the numbers we see that at age 65 the hypothetical portfolio is $4,337,486.69. The amount of pre-tax income inflated at 3% to age 100 is $214,000. The after-tax income in a 35% marginal tax bracket is $139,000.2
If this hypothetical portfolio were to take a 20% loss in one year. You would lose 13 years of income, and you would run out of money at age 86. This also highlights another risk that is often overlooked:
longevity risk, or simply outliving your sustainable income and having to find other means to support your lifestyle. Many financial advisors would instruct you to reduce lifestyle to account for losses. Live on less this also creates a problem because we are not trying to live beyond your means. Just simply maintain pre – retirement standards.
Historically, portfolios typically don’t have just one down year. Consider what happened from 2000 to 2014. Using the Standard & Poor’s 500 total return on those 15 data points, our average rate of return (ROR) would be 6.09% and our actual ROR would be 4.22%. When you calculate this sequence of returns, your income would run out 10 years sooner, at age 78.3
Because of current economic conditions in the United States as well as many other countries. You will face interesting financial challenges in the coming years. History does tend to repeat itself.
The effect of rising taxes, inflation, and market risk and any other unforeseen risks can further reduce your retirement income. This will cut the number of years your portfolio will be able to sustain the retirement income you need. The last thing you want in your retirement is to have to face unforeseen risks. Not to mention be forced to make adjustments will limited choices.
The sequence of returns during the distribution or income phase of your life is a significant risk that you must manage effectively—if you don’t, it may have dire consequences to your retirement lifestyle.