It's natural to want to exit the workforce while the market is up. But knowing that a stock market pullback, correction or crash can occur at any time can help those nearing retirement prepare for the first years of their post-career lives.
What you want to manage is sequence-of-returns risk, or the danger of a market downturn occurring shortly after retiring and forcing you to prematurely sell assets to cover costs. In turn, that could deplete your portfolio and significantly limit its ability to recover even after the market rebounds.
Longevity risk, or the financial danger of outliving one's savings, also presents challenges as life expectancy increases. But sequence-of-returns risk is a more immediate threat for recent retirees — and, in fact, can exacerbate longevity risk.
When retirees experience big losses early in retirement, tapping into their account balances leaves fewer assets in a portfolio to help recover from those losses and subsequent withdrawals. Market downturns that occur later in retirement, on the other hand, may be less impactful (as those savings don't have to last as long).
Investors who are prepared for sequence-of-returns risk are better equipped to properly manage their retirement account withdrawals. In turn, they are able to rely on their savings to sustain them for decades after leaving the workforce.
Here are three ways you can get ahead of that risk.
Where People Are Buying Gold Right Now
Tuck away enough cash to cover at least one year of expenses
In general, money in savings accounts at brick-and-mortar banks is subject to low APYs. Luckily, there's no shortage of cash alternatives that provide better yields than standard bank accounts while keeping funds accessible.
These low-risk, highly liquid financial instruments include high-yield savings accounts and money market accounts at online banks, no-penalty CD and short- and long-term U.S. Treasury bills and notes.
Ideally, people nearing retirement should squirrel away enough money to cover at least one year of expenses (if not two to three years). The idea is that if the stock market takes a turn for the worse in your early retirement years, you won't have to rely on premature withdrawals from your 401(k) or Roth IRA.
The adage "cash is king" didn't make its way into the vernacular because it helps secure early-bird dinner specials and barbershop discounts throughout retirement. Rather, it highlights how having liquid cash offers security and purchasing power during economic slowdowns, periods of heightened market volatility and unexpected life events.
Forget the 4% rule
For decades, financial planner William Bengen's famous 4% rule was the gold standard for retirees to safely and sustainably make their savings stretch.
The strategy calls for withdrawing 4% of your savings in the first year of retirement, then increasing that amount proportionate to inflation in subsequent years. In theory, doing so should result in retirees having financial stability for 30 years.
Today, critics suggest that figure should be closer to 5%. But the issue with the now-antiquated rule isn't its math. Instead, the problem is twofold:
- American life expectancy has increased by more than 27% since 1960, which highlights the persistence of longevity risk.
- The premise of the 4% rule is based on having to liquidate assets in your retirement account in order to generate income.
A better approach to avoiding sequence-of-returns risk is constructing a dividend portfolio. Rather than depleting your nest egg via recurring, inflation-adjusted withdrawals, many Americans can boost their chances of generating reliable retirement income by investing in yield-focused equities — dividend-paying stocks or exchange-traded funds — in a self-directed, tax-advantaged retirement account.
Reinvested dividends in a Roth IRA, for example, continue to grow tax-free and can generate tax-free dividends for those ages 59 1/2 and older after they have been held in the account for at least five years. With this strategy, instead of selling assets to cover expenses, your assets generate yield that can then be used to cover expenses.
Where People Are Buying Gold Right Now
Rebalance your investments ahead of retirement
While rebalancing your portfolio during retirement is important, doing so before you leave the workforce is a critically important step in avoiding sequence-of-returns risk. As we age, our investments should increasingly reflect the need for wealth preservation as opposed to growth. The more conservative the portfolio is, the less prone it will be to unpredictable, volatility-inducing market events.
"Typically, a year out from retirement [is when] we start to get a little more conservative," Kelly Regan, vice president and financial planner at Girard, a Univest Wealth Division, previously told Money.
Here's an example that illustrates how important rebalancing is: In 2007, roughly 25% of 401(k) investors between the ages of 56 and 65 had more than 90% of their portfolios allocated to stocks. When the Great Recession arrived, the S&P 500 lost more than 51% before bottoming in February 2009.
Older investors with considerable exposure to higher-risk growth stocks may not have had enough time to recover those losses before retiring.
The precise asset allocation that works best for you depends on your risk tolerance and how much passive income you'll require in retirement. In general, though, financial experts recommend people in their 60s have a portfolio that's about 60% stocks, 35% bonds and 5% cash.
Taking these three steps can help retirees avoid having to sell shares into a down market in order to cover their costs. After having worked toward this goal for decades, being prepared is the final step in preventing sequence-of-returns risk from spoiling your retirement party.
More from Money:
Ignore the 4% Rule: This Is the Best Retirement Investing Strategy for Most Americans
Gold IRA Kit: Where to Get One for Free
Most Americans Now Say Retiring at 65 Is No Longer Realistic
