How to Ensure Your Retirement Money Lasts

The problem with this is that in almost no individual year will you actually earn 8 per cent. The first year could have a return of 11 per cent, 2 per cent, or even -6 per cent. The second year is the same and so on and so forth.

So the average return number may well be correct, but that doesn’t mean that in the first three years of your retirement you don’t earn 1 per cent or 12 per cent. And it turns out, those returns in the early years matter a lot!

A good quote from commentator Michael Kitces sums the issue up well: “It’s not enough for returns to average out in the long run, if the portfolio could be completely depleted before the good returns finally show up.”

Another way to think of this is that an asset can only be sold once. If you are forced to sell a share at $10 because you needed the cash, the fact that two years down the track it rises to $20 is not at all helpful.

So what’s the plan?

1. Use conservative assumptions when running projections. If you’ve structured your portfolio so it should average an 8 per cent return over the long run, run your projections assuming 6 per cent. If you build in a bit of fat here, poor early returns won’t torpedo your entire plans.
2. Reduce the level of risk in your portfolio in the two or three years leading up to retirement, and keep that risk fairly low for the first three to five years of retirement. So this might mean, instead of being invested 80 per cent in shares and property and 20 per cent in cash and bonds, you drop that down to 50/50 three years out from retirement. And leave it that way for at least the first three years of retirement. In this way your savings will be less exposed to any large drops in investment markets, reducing the likelihood of a negative or even just poor return.Now of course there’s a cost here in that a 50/50 asset allocation will on average earn less than an 80/20 allocation. So this gets back to my earlier observation that sometimes, trying to get the highest return every year should not be the first priority. The objective is to generate income for you for the rest of your life. Whilst maximising returns is important, an understanding of sequencing risk will enable you to recognise that in fact it’s not the most important consideration in the years immediately before and after you retire.

3. Have at least your first year of drawing requirements, and ideally more, in cash, so that if investment markets drop, you are not forced to sell at depressed prices.

   This is something I discuss with clients a lot. The price of an asset, be that a share or property (and perhaps even bonds), matters when you buy it, and matters when you sell it. But in between those two points, the price is at best mildly interesting.

   So in managing for sequencing risk, what we’re trying to do is avoid having to sell assets when prices are down. That’s why, in developing your plans to minimise the risk of your money running out, you need to have at least your first year’s withdrawals, and ideally your first several years, sitting in cash or similar (for example a term deposit). Then, if you are unlucky enough to have share prices say, fall in the first year of your retirement, it’s OK, because you didn’t need to sell any shares then anyhow.

   After this initial retirement period, I’d always advise having at least one year of withdrawals available in cash, but you can afford to have your asset mix get a little more aggressive over time if you wish, as the time span needing to be provided for is less, which serves to reduce longevity risk. In practice I find most retirees value stability, and so tend to maintain a fairly significant and stable allocation to lower risk assets throughout retirement.