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Income in Retirement

Why Flexibility is Key in Withdrawing Retirement Income

A strong retirement plan relies on proper preparation. But flexibility in your plan may be the most important quality you can have.

Articles by Andrew Westlin, CFP®

By Andrew Westlin
Financial Planner, Betterment  |  Published: May 10, 2019

While we can control some aspects of our financial plans, the market remains uncontrollable.

The ability to adapt your withdrawal plan based on market outcomes is key in meeting your retirement goals.

Betterment’s advice helps customers manage around these risks to help your assets last through until end of life.

When I think about financial planning, I often draw parallels with athletic training. Star athletes win over the long-term by remaining flexible and putting in a great deal of effort. Saving and financial planning works much the same way.

We often focus a lot on athletes’ effort—their time in the weight room and practice. That’s like saving. It’s hard work to hold off your spending and put your money aside for later.

But what we often forget is the focus on flexibility that goes into becoming a great athlete. You might be surprised to learn that the strongest athletes spend more time with their backs on a yoga mat than on a bench press. That emphasis on flexibility and our common oversight of it: that’s how I think about financial planning.

Just look at Tom Brady, quarterback for the New England Patriots.

He’s adopted a deeply personalized approach to how he prepares his body. And it’s not a focus on lifting heavy weights. Instead, Brady focuses on pliability and a proper diet. What has that done for him? 6 Super Bowl titles, 3 MVP awards, 14 Pro Bowls, and he’s still dominating the NFL at age 41. He’s defying odds, and he’s mastered longevity in a game where the average career length is just a few seasons.

That same focus on flexibility is critical to how you think about your retirement finances—especially because, like in a season of football, there are many unforeseeable possibilities when investing for retirement.

In this article, we’ll discuss what analysts called the “sequence-of-returns risk” and why it means you need to retain flexibility when you’re nearing retirement.

Why Retiring Changes Your Reaction to Market Volatility

When you retire, your relationship with market volatility sees a sudden change. Instead of depositing against market changes as you do when you’re saving, retired individuals generally just have to ride out volatility, making withdrawals along the way. That can make volatility feel different than it did when you were simply saving for retirement.

The timing of your first withdrawals and market volatility can also lead to very different retirement outcomes. This possibility is called the “Sequence of Returns Risk” in financial planning. While you can’t control this risk specifically, you can control your behavior and flexibility for reacting to the sequence of your returns.

Let’s review the historical performance of a Betterment portfolio at 70% stocks, 30% bonds over a seven-year period from 1/1/2012-12/31/2018 to demonstrate how the sequence of returns matters, especially as you hit your retirement age.

An Overview of the Risk in Your Sequence of Returns

sequence of returns

This Betterment portfolio’s historical performance numbers are based on a backtest of the ETFs or indices tracked by each asset class in a Betterment IRA portfolio as of December 2018. Though we have made an effort to closely match performance results shown to that of the Betterment Portfolio Strategy at 70% over time, these results are entirely the product of a model. Actual client experience could have varied materially.  Performance figures assume dividends are reinvested and daily portfolio rebalancing at market closing prices. The returns are net of a 0.25% annual management fee and fund level expenses.

Backtested performance does not represent actual performance and should not be interpreted as an indication of such performance. Actual performance for client accounts may be materially lower. This figure does not reflect the potential for loss or gain, nor is it any indication of future performance. Backtested performance results have certain inherent limitations. Such results do not represent the impact that material economic and market factors might have on an investment advisor’s decision-making process if the adviser were actually managing client money. Backtested performance also differs from actual performance because it is achieved through the retroactive application of model portfolios designed with the benefit of hindsight. As a result, the models theoretically may be changed from time to time and the effect on performance results could be either favorable or unfavorable.  See additional disclosure here.

Annualized, this portfolio returned 6.9% per year for the time period. But, that’s on average. In actuality, the portfolio did not return 6.9% each year. In fact, the returns in each calendar year were as follows:

2012 +13.3%
2013 +16.2%
2014 +4.2%
2015 -1.2%
2016 +8.4%
2017 +17%
2018 -7.4%

If you invested in such a portfolio, making just one initial deposit and no subsequent transactions, your ending balance would change with the returns, but remember, most investors deposit over time. We generally do not recommend holding onto cash with the idea of depositing at the “right time”, as we believe that the amount of time spent in the market is more important than timing the market. But once you’re retiring and start making withdrawals, this is where the order of returns can make a huge difference in your final outcome. If your first year of retirement is like Year 7, and you’re making withdrawals, that impact on your future portfolio value will look far different than if your first year looks like Year 2.

Depending on the timing of withdrawals, two customers who start off with the same balance and invested in the same portfolio at the same risk level could have drastically different end results. Withdrawing while markets are down means that you may be selling a higher quantity of shares to generate your withdrawal amount. When markets eventually recover, your portfolio has taken a hit because you have less shares in your account that are taking advantage of the market rebound.

When we offer advice to customers, we want them to focus on what they can control, and the sequence of returns risk isn’t controllable. But you can control your behavior, fees, target allocation, and taxes. The key is flexibility in how much you’ll spend in retirement and solid planning to make that possible. Below are some of the ways that Betterment helps you maintain flexibility and mitigate risk.

How Betterment Helps Manage the Sequence of Returns

While there’s no getting around the inherent risk in making the shift from planning for retirement to withdrawing retirement income, Betterment has several components that aim to manage your risk.

1. Automatically adjusting your allocation

The challenge many people face is having too risky a stock-to-bond allocation near retirement. This can augment the impact of the sequence of returns risk. Over time, as you near a goal like retirement, your risk level should adjust accordingly. Betterment automatically manages your allocation, adjusting by rebalancing according to our automated allocation advice.

By reducing volatile assets, your portfolio is better protected against large market swings. With a narrower range of outcomes, sequence risk can be mitigated. Our retirement income advice recommends a gradual reduction of risk throughout retirement, starting at 56% stocks and gliding down to 30% stocks towards the end of retirement. You can turn automatic allocation adjustment for your retirement income goal at Betterment.

2. Rebalancing using deposits, withdrawals, and dividends.

Any cash flows, like withdrawals and dividends, are automatically used to rebalance your Betterment portfolio to keep your portfolio within a target allocation as it drifts with market returns. This works to your advantage when rebalancing in down markets – if stock markets are down and your bonds are overweight compared to stocks given your target allocation, we will first sell bonds when you when you make a withdrawal. This leaves more of your portfolio invested in the stock funds that form part of your target allocation.

3. Retirement income withdrawal advice

Betterment aims to account for the sequence of returns risk with our safe-to-withdraw recommendation for your retirement income goal. We provide you with a personalized recommended withdrawal amount based on your portfolio’s balance and risk level. This recommended withdrawal amount is estimated, assuming that you’ll see only the lowest 4% of projected expected returns—a very conservative projection—so, in other words, our advice provides a 96% likelihood that you will not run out of money during your lifetime.

The consequence, of course, is that if you follow our withdrawal advice, a low returns period could mean our recommended withdrawal is less.

This same advice is incorporated while you are accumulating wealth for retirement. We account for this withdrawal approach when estimating how much you’ll need to save in order to reach your desired retirement spending goals. See our Retirement Methodology for more detail.

While our retirement withdrawal advice is designed to be conservative, the advice you receive from Betterment is dynamic. Your recommended monthly withdrawal amount could change based on market performance. When markets are up, our advice will show that you might be able to withdraw a bit more (but beware of lifestyle creep). When markets are down, we might suggest you not withdraw quite as much. Over time, flexibility in your spending can extend your capital if necessary, helping to prevent your portfolio from being depleted prior to the end of your lifetime.

Additional Ways You Can Stay Flexible to Mitigate Risk

Aim to set an income floor.

If you can’t be flexible in your spending, or just hold a strong preference to have guaranteed income to cover your expenses, you may consider options to create an income floor. Careful Social Security planning can help you maximize your benefit based on your needs. You may receive a pension, depending on your work, and if given the option, may choose to annuitize rather than take a lump sum. Other options could range from purchasing an annuity product to finding part-time work. If you are considering any of these options, our team of financial experts is able to address your questions.

Express your preference for income-focused portfolio strategy.

Another option could be to explore removing the risk of holding stocks in your portfolio. While this isn’t recommended, we understand many people have a strong bias to only generating income in retirement, which is why we offer target income portfolios by BlackRock in Betterment accounts.

Have a safety net, even in retirement.

Create a separate, low-risk portion of your overall portfolio that covers six months of expenses for the possibility of a poor sequence of returns. Betterment offers a Safety Net goal, which is intended to help you set aside and grow your emergency money.

Aim for retirement savasana—final relaxation.

Sequence of returns risk is a part of retirement you should be aware of—not afraid of. Betterment’s portfolio advice is designed to help you plan around it; just remember to practice your retirement yoga regularly.

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