Kiplinger’s recent article, “1 Critical Mistake to Avoid When You Retire,” explains that preparing for your financial future means thinking about things that aren’t always within your control. While it’s not that difficult to choose your target retirement date or to budget what you’ll need for monthly income, projecting portfolio returns, life expectancy, taxes, inflation and health care needs requires some strategic guesswork. The thing that creates the most problems is the assumed average rate of return on your investments.
Some financial plans will create a false picture in relying on average rates of return. A solid plan needs to take into account market volatility. Your retirement strategy is most sensitive to market swings during the five years before and after your target retirement date. That’s because your savings are at their height and most susceptible to a market correction. If you take on losses near your target retirement date, it can have significant consequences. Even though people are aware of this fact, they will still rely on “age-appropriate” mixes of stocks and bonds to attempt to mitigate this risk. However, this solution, which is designed to deliver an average target rate of return over time, may not be effective if the market doesn’t follow your projection and delivers an actual negative return when timing is crucial.
Market volatility can be a consequence based almost exclusively on timing. If you’re working, a market drop can be an issue, but you don’t need that money immediately. You have the time to ride it out, and your contributions will help your recovery. But when you’re close to or in retirement, it’s different. A market drop directly impacts your primary sources of income, and you’re not adding to those accounts. You’re using them to pay for living expenses.
A wise retirement plan needs to be designed to withstand volatility and to provide desired income when needed, regardless of market conditions. Mitigating this volatility risk is a must to keep your plan on track and on time.
There’s no need to exit the market entirely, but you should consider allocating some of your portfolio to assets that are linked less to the market, like bonds.
Look at the potential impact that a market reversal may have on your plan, and determine the rate of return your portfolio needs to provide sustainable income during retirement. That’ll help you see how much risk exposure is necessary to achieve that goal.
Reference: Kiplinger (August 2017) “1 Critical Mistake to Avoid When You Retire”
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