The Single Biggest Risk to Your Retirement Income...

John Stregger |
Categories
Retirement

November is officially financial literacy month in Canada.1 I could think of no better time to relaunch my newsletter than this month! So, if I'm going to relaunch the newsletter, I thought it best to deal with the number one financial risk facing Canadians that are approaching retirement. Ask most people over the age of fifty and they will tell you that having enough money to retire is their biggest financial concern. That concern is definitely real but very few people we meet realize all of the negative factors that work against them in retirement. If your concern is having enough income at retirement then you should also be aware of the biggest risk to your income which is referred to as "Sequence of Return" risk. I find the best way to explain this risk is to use an example.

What is Sequence of Return Risk?

The sequence of annual investment returns of your portfolio matters greatly during retirement. While investment returns are not guaranteed, below are two hypothetical examples which illustrate how the sequence of investment returns can impact your portfolio during the accumulation phase leading up to retirement, and during the withdrawal phase once you enter retirement.

As the table above shows, all three scenarios have an average ten-year return of 7%. However, the sequence of the calendar year returns is different in each scenario. During the accumulation phase, the sequence of investment returns does not affect the end portfolio value.

Unlike the accumulation stage, the sequence of returns during the withdrawal phase significantly impacts the end value of the portfolio – and consequently the portfolio’s ability to provide you with long-term income. That is, if you don't get the rates of return in the right order, you run the risk of running out of money sooner!

What Can You Do About It?

The key to protecting your portfolio (and your income) during the withdrawal phase is to organize a contingency plan for your withdrawals/income when markets are down. Sometimes referred to as a "Cash Wedge Strategy" or "Volatility Buffer" this is a strategy which can help insulate your income from market downturns. The strategy works as follows by dividing your retirement assets into 3 main categories:  

  1. The Cash Wedge: A portion of your projected retirement income – usually one year’s worth – is allocated to a conservative, highly accessible investment such as a money market fund. This portion of the portfolio helps to create a more stable platform from which you begin drawing your retirement income.
  2. Short-Term/Conservative Investments: The second and third years’ projected retirement income is allocated into a low volatility short-term investment, such as a 1- and 2-year GIC, investment savings account, or bond fund. This helps to create a relatively stable part of the portfolio that may grow without taking on too much risk. In years two and three, these investments are used to replenish the Cash Wedge.
  3.  Diversified Asset Mix: The remainder of the portfolio remains invested in the asset mix that suits your individual investment profile and comfort with investment risk. This allows you to stay invested and participate in the market. Eventually, potential profits are moved from this part of the portfolio into the less volatile short-term investments and into the Cash Wedge position to create income for year four, and subsequent years.

Using the Cash Wedge strategy helps minimize your retirement income risk. Because you are drawing income from the stability of the Cash Wedge, the rest of your portfolio is given time to overcome market swings. Over the long term, you have the potential to earn more from your portfolio and get the most out of your retirement income.

We offer a number of models to test your current strategies and how your future income can hold up against Sequence of Return Risk.  

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1. https://www.canada.ca/en/financial-consumer-agency/campaigns/financial-literacy-month/about.html

Insurance products, including segregated fund policies, are offered through Discovery Wealth Management Inc., and Investment Representative John Stregger offers mutual funds and referral arrangements through Quadrus Investment Services Ltd.

 

Make your investment decisions wisely. Important information about mutual funds is found in the Fund Facts document. Please read this carefully before investing. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. Unit values and investment returns will fluctuate.

This information is general in nature, and is intended for informational purposes only.  For specific situations you should consult the appropriate legal, accounting or tax advisor.