As You Get Closer to Retirement, the Rules of the Game Are Different

Hand touching a chess piece

Whether you realize it or not, there are two distinct stages of your investment lifetime – accumulation and distribution – and the rules for navigating each stage are quite different.

Many investors typically focus first and foremost on accumulation, ensuring that their investments are earning money; but they often do not understand what is involved in making the transition from accumulation to distribution, or the point at which they will begin drawing money from their portfolios.

Yet the differences between the two stages can be critical. When you’re accumulating money, time is on your side: you have the ability to power through market downturns and still put money away. But you don’t have the same luxury when taking distributions; in fact, time is not on your side when you’re withdrawing money on a regular basis.

The factors that help you accumulate your wealth can actually work against you when you are withdrawing (or, distributing) that wealth, such as:

  • How you look at risk in your portfolio
    Your sensitivity to risk becomes greater in retirement. As a result, as you approach retirement age, you need to start looking at risk differently than through the traditional “100 minus your age” rule of thumb that’s typically used to determine how much of your portfolio should be in equities. In fact, as you near retirement, you should carefully consider the percentages of the different asset classes you own in order to minimize the chances of running out of money. While most people have heard of an asset allocation plan, a risk allocation plan is equally as important during the distribution phase. Your financial advisor can help you evaluate your risk tolerance and build a retirement plan that likely involves a combination of risk avoidance, risk management, and risk transfer.
  • The impact of volatility in the market
    During your accumulation stage, volatility and dips in the market can actually help you. If you’re saving money monthly and/or contributing into a 401(k) plan, you’re still buying into the market during the dip. Then, when the market recovers, you will have accumulated more shares in your portfolio at an even better price thanks to dollar-cost averaging. Read our recent blog, Tune out the Noise, to understand how to leverage volatility in your portfolio. When you are making withdrawals, however, that same volatility can work against you… which segues to the next factor to consider:
  • The sequence of taking investment returns
    We broached this subject in our Three Brothers blog post. In this hypothetical story, even though the second brother was taking the same 6% withdrawal rate as his siblings, his portfolio ran out much more quickly than his brothers’ because he began his retirement just as the market pulled back. Like the hypothetical second brother, investors too often do not give proper consideration to the sequence of withdrawals. If you take regular distributions from equities during periods of market volatility to pay bills or fund your retirement needs, you could be selling at a much lower price. When the market or that investment recovers, not only do you have fewer shares, but your investments have to perform even better just to get back to where you were pre-dip. Investors should consider asset types when making withdrawals to help protect against running out of money too early.

When should I begin my transition from accumulation to distribution?
If retirement is 5 to 8 years in your future, it’s time to sit up and pay attention. The investment allocation in your retirement portfolio at this point should be driven largely by your projected withdrawal rate and the time horizon – that is, how long you’ll need to draw that money. In addition, you’ll want to review your portfolio to ensure that it is built in a way that allows you to take the right distributions at the right time, maximizing the overall value of your portfolio.

Picture your retirement portfolio as a stack of money you will pull from, and that it will take you approximately 30 years to get to the bottom of the stack. Fiscally, it makes sense for your stack of money to be conservative on top (cash) and growth oriented (stocks) on the bottom. Because depending on how much money you plan to withdraw each year, the money on the bottom of the stack could be invested in riskier assets, generating greater returns far longer than the fixed-income assets at the top of the pile.

How do I know what I’ll need for retirement?
It’s common for people planning their retirement to experience a heightened sense of anxiety that comes from not understanding how market volatility and risk can affect their long-term financial goals and objectives. In fact, most people are unaware that:

  • You are in a period of increased vulnerability to market fluctuations when you are within 5 years of retirement.
  • Volatility is a much bigger factor once you enter the distribution phase.
  • The sequence of taking your returns can be as important as the returns themselves.

To ensure you’re properly addressing risk and volatility in your retirement portfolio, ask your financial advisor to run a cash-flow analysis and review your investment allocation. Your financial advisor can help you to identify your needs and create a customized financial plan that guides you from the accumulation stage to the distribution stage and helps to ensure that you have the money you need to meet your retirement goals.