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The Risks of Recession During Retirement

January 12, 2023
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The Risks of Recession During Retirement

The Current Outlook

As 2022 comes to an end, many investors are left feeling deflated and hopeless as they have watched their asset portfolios post negative returns month after month with no place to hide. Inflation is still causing issues across the board with prices staying stubbornly high despite the Federal Reserve’s interest rate hikes. This will be the first negative return in 5 years, and the most significant downturn since the Great Recession in 2008.  Although the National Bureau of Economic Research (NBER) has yet to define this period as a recession, many investors believe the United States is currently in a recession or heading in that direction in the coming months.

This will cause the markets to contract further, increase cash holdings, and lower the overall level of debt and economic activity. While these things are typically seen as negatives, they can be beneficial to the health of the long-term market, similarly to how a “controlled burn” can help a forest grow in the future. For those investors nearing or entering retirement, the “long term” does not give them much hope, as they do not have as much time to recover before needing to use their retirement savings. That being said, a recession does not have to spell disaster for retirement plans. There are tactics investors can take that will help recover short term losses with long term assets. With the appropriate strategy and the help of a financial advisor, retirees can survive a bear market.

Sequence of Returns Risk

A retirement portfolio is usually not just a lump of cash in a savings account that is drawn inexorably down to zero, but rather a mix of investments that include both income and growth over time. Ideally, as an investor takes withdrawals, the growth of the investments will at least cover a portion of the amount taken out. Therefore, making the money last longer. However, if there is a downturn in the market or a recession, this does not occur.

The point during retirement at which there is a downturn can have a significant impact on the investor. When you start withdrawals from your portfolio as it's losing value, you have to sell more investments to raise a set amount of cash. Not only does that drain your savings more quickly, but it also leaves you with fewer assets that can generate growth and returns during potential future recoveries. In contrast, if a decline occurs later in your retirement, you may not need your portfolio to last as long or continue growing to fund a long retirement. This phenomenon is known as the sequence of returns risk. Simply put, the order and timing of poor investment returns can have a lasting impact beyond the immediate hit to your portfolio.

As shown below, investor 1 has significantly less money after experiencing a downturn of 15% in the first couple years of retirement, opposed to investor 2 who experienced the same downturn but much later into their retirement.

So, where does that leave investors today in 2023 who might become “Investor 1” due to the current economic market? The good news is that there are things these investors can do to better their financial situation and help the recovery of assets in the near- and long-term future.

 Investor Strategies

At all times, but especially in a bear market, it is imperative to maintain a proper diversification of assets. As you near or enter retirement, investors should scrutinize their asset allocation to determine whether any changes should be made to the portfolio holdings. For example, maintaining a “reserve” of low-risk bonds, money markets, and cash for one to two years of expenses while simultaneously holding higher risk bonds, stocks, and other equities for use seven plus years into retirement is an approach that is appropriate for many investors. This strategy will protect assets in a bear market, while also capitalizing on gains in a bull market. To learn more on how this bucketed approach can benefit a specific situation, please reach out to a member of the G5 Financial Group.

 If investors don’t have reserves they can pull from, the best approach, if possible, is to reduce the amount of withdrawals from their accounts. Although many investors use their withdrawals for living expenses, there is often room in anyone’s budget to reduce discretionary spending and “tighten their wallets” while waiting for the recovery of the market. Additionally, the Federal government just announced the adjusted cost of living to social security payments for 2023 is 8.7%. This is the largest increase to social security in more than 40 years and is a direct reflection on the high inflation rates from 2022. This increase will boost retirees' monthly payments by more than $140 to an average of roughly $1,827 for 2023. Retirees should utilize this increase as a chance to reduce the amounts coming out of their investment accounts for living expenses. The amount reduced in withdrawals is about a one-to-two correlation with the amount of time it takes to recover losses. See the illustration below for an example.

Therefore, any reduction in withdrawals will go a long way to helping the recovery of assets further into retirement. Truly, although it may feel like the right thing to do, one of the worst things an investor can do in a bear market is get out of it. This takes paper losses and makes them realized with no hope for recovery. Furthermore, investors who decide they want to put the money back in once “the market recovers” are often too late and will miss out on the opportunity for a buyer’s market. For more in depth analysis and help determining discretionary spending, please reach out to a member of the G5 Financial Group.

Takeaway

Downturns are always going to occur in the market, but the markets will also always go back up. The biggest concern that investors should worry about is timing. It is impossible to truly know when the markets will hit their bottom or when they have hit their top. Therefore, the best thing that an investor can do is to diversify their portfolio, take a long-term approach (where possible), and also consult a financial advisor who can help plan accordingly for retirement and beyond. 

 

Sources:

https://www.schwab.com/learn/story/timing-matters-understanding-sequence-returns-risk#:~:text=At%20issue%20here%20is%20a,long%20your%20retirement%20savings%20last.

https://www.forbes.com/advisor/retirement/recession-retirement-planning/

https://www.aarp.org/money/investing/info-2022/recession-survival-guide.html