Financial Insights

Managing Return Risks While Taking Withdrawals From Your Portfolio

There is some debate as to whom to attribute the often-co-opted quote about focusing on one’s journey as opposed to their ultimate destination. Whether it’s Ralph Waldo Emerson or T.S. Eliot, I doubt either had retirees fixating on their investment portfolio returns in mind when they derived the phrase.  It is on the journey where we spend most of our time and this concept certainly applies to retirement.  How much you’ll enjoy your retirement journey will depend to a certain extent on your investment experience.

Investment headlines in 2023 have focused on the resiliency of the S&P 500 driven by the Magnificent 7 stocks.  These seven names account for the lion’s share of the index return through June 30th of this year.  Investors have very short-term memories, as those same seven stocks were the force behind the same index ending 2022 down -19.64%.  Investors wishing they only owned or were overweight these seven companies so far this year may not feel the same way if they remembered how poorly they performed in 2022. This is especially true if they need their portfolio to live off of and are taking withdrawals each year to cover their spending needs.

Wild swings in a portfolio from year to year have no actual impact on its terminal value during the accumulation/savings phase of life, as long as there are no additional investments or withdrawals.  Ultimately, the average ending return will remain the same and the trap here is to go all in and chase portfolio ‘growth’ as a result.

When investing in retirement or for some other goal that will require withdrawals, we need to consider the timing of when one will need to take distributions, and how long those distributions will continue.  Most investors in retirement today do not have the luxury of turning off their spending for a year, and therefore the withdrawals from their portfolio, in order to wait out a downturn in the markets. They run the real risk of running out of money sooner as a result of the timing of their need to withdraw from their portfolio when its value is down.  This concept is known as Sequence of Return Risk and proves why focusing on maximizing a potential return instead of on the return you need with less volatility in order to meet your goals is ill advised.

Let’s look at how varying sequences of return can impact a hypothetical retiree starting with a $1 million investment portfolio looking to live off of his/her savings.  On the chart below, we plotted the actual return of the S&P 500 index from 2000 – 2022 three different ways for three different sequences of returns.  In all three scenarios we assumed the investor needed a 4% annual withdrawal that increased with the historical inflation amount from that same time frame (2.5%) each year.

During the time frame we measured for this exercise, the annualized average return for the S&P 500 index was 5.90%.

The chart illustrates how the timing of retirement withdrawals can lead to very different outcomes.  Despite beginning with an equal amount of $1,000,000 and employing the same 4% withdrawal rate adjusted for inflation each year, the three retirement scenarios finished in three very different places. The compounding effect of portfolio withdrawals exacerbates losses, impeding recovery from a decline, particularly if it occurs early in the sequence.

This was the case in Scenario A, which would have been the actual experience of investors trying to live off a portfolio invested 100% in the S&P 500 index.  When withdrawals are factored in, even portfolios with similar characteristics can yield remarkably different results.

Rather than focusing on trying to maximize absolute return, what steps can we take to minimize this Sequence of Return Risk to increase the likelihood of meeting retirement spending goals? (See You Can’t Retire on an Index).

Cash Reserve

During your working years, it is essential to establish an emergency fund to ensure that unexpected financial crises do not require you to dip into your retirement savings. Once you retire, it is still good practice to maintain a balance allocated to cash and consider a bear market as an additional emergency to manage. For convenience and security, consider maintaining at least six to 12 months’ worth of spending needs in cash or cash equivalents.  Keeping a little more in cash in early retirement years could provide some more needed comfort as you manage the uncertainties of switching from the accumulation phase to distribution mode.

Diversify with Bonds

At ACM Wealth, we stress that bonds can serve as ballast to a portfolio during retirement and, at today’s yields, bonds offer an attractive stream of income for retirees.  We also know that over the long-term stocks tend to outperform bonds, however, bonds tend to have less volatility than the stock market, and historically have been less correlated to stocks, meaning their prices can move in the same direction with less magnitude or even in the opposite direction (AGG up 7.90% in 2008).

Importantly, lower portfolio volatility helps prevent investors from letting their emotions take over when fear grips the markets and triggers a desire to sell out of their investments entirely at the worst times (the bottom).  This can be catastrophic.  Depending on anticipated spending needs and the expected length of retirement, allocating a portion to bonds can serve to smooth out the inevitable bumps in a retirement portfolio’s journey and increase the likelihood of staying invested/success.

Increase Equity Dividends

Not all stocks are created equal. Stock returns include two components – price appreciation and income in the form of cash dividends paid for simply owning a stock.  The S&P 500 index is “market cap weighted”, so returns from owning the index are skewed toward the largest companies in the index, regardless of whether they pay dividends or not.  The Magnificent 7 stocks pay little or no dividend at all.

ACM Wealth incorporates dividend stocks as part of our yield-targeting strategies for retirees seeking a stable and reliable source of income in retirement.  Companies with a history of paying dividends tend to be well-established and financially stable, offering investors a consistent stream of passive income along with the potential for capital appreciation.  When markets are down and stocks prices have sold off, companies can still maintain their dividend payments, allowing investors to use this cash towards meeting their spending needs, without having to rely on selling their underlying securities, reducing their portfolio principal.  Changing your stock exposure to a higher weighting of dividend paying stocks can provide more dependable income to be used as part of a retirement withdrawal strategy.

Dynamic Withdrawal Strategy

Life happens and, as a result, your spending in retirement will not be linear, so why assume annual withdrawals from your portfolio will be?

When planning for retirement, we take this conservative approach but with discipline and guidance, imploring a dynamic withdrawal strategy to help extend the life of your investments.  Bucketing expenses into different categories, like essential and discretionary, can allow you to cut back on unnecessary distributions during a market downturn, keeping your total withdrawal rate in check.  You can also implement a more systematic approach to annual spending increases based on market values or other variables because as we’ve seen, especially this past year, that inflation does not tend consistently increase either.

Lastly, you can also set rules for what investments to take your withdrawals from in your portfolio that can change with market performance. Why sell pro-rata across your account each year? It may make sense to harvest more income or use the proceeds from a maturing bond while stocks are down, and leave growth-oriented assets invested to give them time to recover.  Understanding these dynamics and how to manage them is an area we focus on when providing advice to clients on meeting their retirement spending needs.

The path of your investment returns matters just as much, if not more, than your expected average return when living off your portfolio in retirement.  Although some investors may feel a sense of FOMO right now as the Magnificent 7 stocks are propelling the S&P 500 index higher in 2023, remember that it was these same 7 companies drove the market lower last year.  Relying on growth portfolio for withdrawals in a year like 2022 would have compounded the problems caused by being concentrated in these names.

Focusing on achieving what you need you portfolio to do for you, rather than reaching for top-end performance, and incorporating some fundamental retirement portfolio withdrawal concepts may help mitigate the Sequence of Return Risk.  No one gets style points for taking a more volatile and treacherous path through retirement, so let ACM Wealth help you take the smoother route with more enjoyable scenery.

The foregoing content reflects the opinions of Advisors Capital Management, LLC and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.


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