by Christopher G. Peterson, CFP®
When you are investing for a life event, like retirement, that may be decades away a drop in your portfolio value may be uncomfortable. Most ride it out and may see it as an opportunity to buy. For those in retirement the view is probably different but there are different levers we can use to help our retirement goals.
Ideally, no one wants to enter retirement during a prolonged and significant market decline. After all, a market shock reduces a client portfolio's value, diminishing the amount that can safely be withdrawn. When this happens, historically there has been a silver lining: lower investment valuations usually raise expected future returns, potentially offsetting some of the current decline.
The Problem
You depend on your retirement assets to deliver a certain return year after year—from interest, dividends, and capital appreciation of your investments. When a market downturn knocks down the value of your nest egg, it also takes a large bite out of current and future earnings potential. That problem compounds when the downturn happens toward the beginning of retirement or lasts for multiple years in a row.
That doesn’t mean you’ll have go back to work—if that’s not your desire—nor do you necessarily have to pinch pennies until it hurts. Your portfolio spending strategy can make all the difference. Three popular strategies are:
Dollar plus inflation—You determine a set amount to spend and add the cost of inflation annually.
Dynamic spending—You adjust spending each year to adapt to market conditions. Set a ceiling and floor for how much to take from your portfolio (for instance, 5% greater than the previous year’s spending in exceptional market conditions or 1.5% less than the previous year in a poor market).
Percentage of portfolio—You determine a set percentage to spend each year, no matter the size of your portfolio. 4% is a common withdrawal rate.
A reduction in annual spending can significantly boost the chances of your retirement portfolio lasting the rest of your lifetime. Further, a dynamic spending strategy gives you the flexibility to spend more in good market conditions while only having to cut back a little when markets retreat.
Note that the calculations here exclude Social Security and other possible income, such as pensions, rental property, or supplemental employment after retirement. Such income streams can enhance the chances of an individual successfully maintaining their portfolio through the end of retirement.
Using Simulations
Investors are more and more familiar with Monte Carlo simulations on your portfolio or financial plan. You will receive a projection or probability of success for your current plan. One problem with Monte Carlo results is for some people anything less than 100% success is not acceptable. A better way to frame Monte Carlo is to think of the gap between your score and 100% as the probability that the plan needs to change. So, if you have an 80% chance of success the other way to consider the numbers is you have a 20% chance that you may need to make a change to your financial plans.
If we are in the middle of a stock market drop, rerunning a Monte Carlo simulation is a normal thing to do. Depending on the results and your comfort with the number you may need to make adjustments to your spending but my experience is the changes are usually small. If someone is using a dynamic spending/withdrawal plan you are taking a lot of the risk out of running out of money.
Higher Inflation
Like many investors, you're probably concerned about the potential for higher inflation, and you're considering your options to help maintain purchasing power and stability in your bond holdings.
It's not hard to see why. The rate of COVID-19 vaccinations in the U.S. is accelerating, raising hope for a robust post-pandemic economy. Federal Reserve Chairman Jerome Powell has said the central bank will tolerate temporary inflation spikes above the Fed's long-run inflation target of 2%. And government spending/stimulus has added trillions of new money to consumers pockets.
The question is: Will inflation see a sustained move upward or just a temporary boost? In either case, what can be done to your asset allocation plan?
Inflation in the next 1 to 5 years
We have already seen the market price in higher inflation expectations. Market pricing of inflation is close to the upper end of the historical range, but we believe near-term risks are still skewed to the upside.
The potential for a short-term inflation overshoot is real, as macroeconomic factors, higher commodities prices, supply chain issues and the base effects of the very low inflation in 2020 can gradually push up market expectations. Additionally, any weaker-than-expected data will only serve to reinforce the accommodative stance of the Federal Reserve.
Inflation over 5 years
The recent measures enacted through fiscal and monetary policy are meant to close an output gap caused by the pandemic. Sustained higher inflation would need to be achieved through additional measures and higher growth. However, Vanguard research believes that while there will be cyclical bursts of inflation, we won't see runaway inflation anytime soon.
TIPS to the rescue?
Treasury Inflation Protected Securities (TIPS) may help protect the value of, and income from, your fixed income portfolios. The principal of a TIPS bond rises—and falls—with the nonseasonally adjusted Consumer Price Index, and the coupon payment is also recalculated off this adjusted principal amount. This is how TIPS can deliver inflation protection and a real return. On the other hand, nominal Treasury bonds deliver a fixed coupon amount, so inflation can chip away at a nominal bond's real return.
If you are more sensitive to potential increases in inflation due to near-term income needs—particularly those in retirement or with known liabilities—having an allocation to TIPS can be a helpful hedge against inflation risk. Additionally, TIPS are not included in the broad U.S. Aggregate Bond Index. Having an allocation to TIPS may provide additional diversification benefits to your portfolio.
Problem areas of TIPS include:
CPI may not reflect your inflation rate
Bonds naturally adjust to inflation through changes in prices
Poor performance during deflation
Cash flow is unpredictable because the yield is dependent on future inflation which is not known
Remember that bearish markets are inevitable. While it’s impossible to accurately predict when they will appear, you can take steps ahead of time to minimize their long-term impact on your retirement. There are levers that can be pulled to help increase your chances of meeting your retirement goals.
Sources: Vanguard Advisor Services; Kitces.com