With people living longer, it is important not to view retirement as the finish line for your retirement investment program. At the same time, it can be equally important not to view post-retirement investing as business as usual. With Americans typically living about 19 years after they reach the traditional retirement age of 65, it is usually necessary to keep some growth components in your portfolio after leaving the workforce, primarily to help purchasing power keep up with inflation. However, in assessing how big a role growth should play in your investment mix, the key is to recognize that a profound shift in risk exposure occurs once you retire. The source of that shift? The transition from positive to negative cash flow.
Same market, different resultsYou may have heard of dollar-cost averaging. This is the technique of earning more by making consistent investments in the market throughout its ups and downs, which works because in effect you can buy more when the market is down than when it is up. If those consistent investments enhance investment earnings, what impact do you suppose consistent withdrawals from an investment program will have? Withdrawals increase the impact of market downturns, even if they are temporary. Effectively, withdrawals amplify volatility. Consider three scenarios, all investing in the same market environment and earning the same investment returns. In one, which you can think of as the control in this experiment, no money was put into or taken out of a $500,000 portfolio during the period in question. In the second, $20,000 was added at the end of each year. In the third, $20,000 was subtracted at the end of each year. The first year, the market loses 15 percent. The next year, the market gains 20 percent, so the overall return is positive. The portfolio that neither added nor subtracted anything shows a $10,000 investment gain. The portfolio that added $20,000 a year shows a $14,000 investment gain (i.e., the increase not including the money added), while the portfolio that withdrew money shows only a $6,000 investment gain.
The variances are because the portfolio that was adding money had more invested to capture the market's recovery after the bad year. In contrast, the portfolio that was subtracting money effectively locked in the losses on the money that was withdrawn after that bad year.
What to do about itBecause withdrawals can amplify investment volatility, there are some things you should consider once you reach retirement age:
- Downshift your asset allocation. Don't go too conservative -- you still need that inflation-fighting growth component -- but recognize that losses can be more costly once you start withdrawing from the portfolio.
- Consider working part-time. Any income you earn can reduce the amount you need to withdraw, and thus reduce the impact of your cash flow on your investment returns.
- Adjust on the fly. There is no telling when volatility is going to strike or to what extent, so you need to re-evaluate how much you can afford to withdraw each year. If you take a big hit somewhere along the way, you may have to reduce subsequent withdrawals to make the portfolio last as long as you had originally planned.