No matter how good you are about setting up a safe withdrawal strategy for your portfolio during retirement, there is one thing that most long-term investors can’t overcome: market fluctuations or volatility.
Timing of Distributions
Over the long-term, return averages may even out. Still, if the timing of a volatile market is unfavorable to one’s retirement income needs, there is always the possibility that withdrawals made during the down years will deplete an investor’s portfolio faster than expected. It can be challenging for an investor or a financial advisor to get the portfolio back on track since there's less money invested when the market recovers. This risk that the timing of withdrawals from a retirement account will have a negative impact on the portfolio's overall return in the long term is called sequence-of-returns risk.
That's why many savers and advisors strategize to take minimal or no distributions from their equity portfolios during those years when stock markets are underperforming. They can do so by setting up investment buckets that are designed to be used for withdrawals during market lows, or by putting in place a withdrawal strategy whereby equities are only sold when the markets are up, and bonds are sold, or cash is used when the stock market is down.
However, the caveat that comes with this scenario is that when these strategies are used along with a simple portfolio rebalancing, the result is typically no better than if the portfolio had been managed on a total-return basis. That’s because simple portfolio rebalancing has a built-in positive effect, which helps offset unfavorable liquidations. In fact, using this process ensures that investments that are up are being sold, while investments that are down are being purchased. So some advisors may want to consider using rebalancing as an alternative to creating buckets or rule-based strategies.
Safe Haven Investments
A popular solution to selling equities at a loss is to establish a set of rules that state that equities will not be sold in down markets and that the advisor will divide the portfolio into three or four buckets that include equities, bonds, and cash or Treasury bills. This way, the client can take distributions from equities when they are up, from bonds when equities are down and from Treasuries when both the bond and equity markets are at a low point. In this scenario, liquidation occurs at the end of a year, and the portfolio is rebalanced at the start of the year.
A look at the year-to-year returns using this type of method shows that liquidation can, indeed, be utilized, when withdrawing assets from the varying buckets over time, and thus avoiding selling investments after they have already declined. In this way, a retiree should be able to preserve their principal while at the same time keeping up the suggested 4% withdrawal rate, even through difficult markets.
While many advisors attempt to manage a portfolio holistically, on a total-return basis, the approach is not consistent with a bucket-based liquidation strategy that incorporates decision-based rules. In fact, portfolios that are managed using a total-return approach are often also rebalanced systematically so that they are kept on target through the sale and purchase of assets. That said, there is still no guaranteed strategy that allows one to avoid taking retirement income distributions from asset classes that were down in the previous year, while only taking distributions from investments that were up.
The Bottom Line
To offset retirement portfolio depletion when stock markets are down, retirees can set up strategies for taking minimal or no distributions from their equity portfolios during times of equity market underperformance and instead withdraw from bond or cash buckets. They can also use similarly styled total return strategies.