Retirement Trap = Retiring in Periods of Poor Investment Returns

Whilst no one has a crystal ball when it comes to predicting investment returns if you retire in periods of poor investment performance you could be in for a shock. With an increasing life expectancy many retirees now face the prospect of outliving their retirement nest egg.

 The average person enjoys over 25 years in retirement, but a prospective retiree usually fails to consider the underlying investment climate at that time, and the impact that this will have on the sustainability of our capital sum .

 With the cash rate at historic lows, the usual USA debt concerns and volatile investment conditions these are concerns for those considering semi or full time retirement. In the event that a retiree experiences a significant loss of capital in the early years of retirement, it can be difficult to recover from this position without the security of full time employment.

 The crucial time zone for any person retiring is the period 5-10 years both before and after the retirement date. It is during this period that the difference between having a comfortable or struggling retirement is determined, and for the most part this is out of the retiree’s hands: it depends on the returns that a portfolio obtains.

 The younger you are and the longer you have until retirement, the smaller the impact on your overall plans. For example, if you are 30 years of age a return of minus 20% won’t have the same impact as a 65 year old who is not working and drawing down on this sum.

 Where you experience a period of poor returns, in the “retirement risk zone” (ie 5-10 years before and after retirement), there is a risk that this will substantially erode your capital, and your income needs may not be met over the long term. The reason for this unfortunate scenario is that, given your age, you won’t have the time in which to recover your capital (time that a younger investor will have).

Let’s have a look at how this works in practice, assuming you are a 65 year old retiree with a capital sum of $250,000, and you need to draw $22,500 per annum to meet your income needs.

 Example 1

Years after retirement Investment Return Capital sum at year end
1 -13% $195,000
2 -21% $131,550
3 +7% $118,258
4 +12% $109,948
5 +15% $103,940

The capital sum remaining after 5 years would be $103,940

Example 2

 In the next example, we have reversed the order of investment returns look at the difference:

Years after retirement Investment Return Capital sum at year end
1 +15% $265,000
2 +12% $274,300
3 +7% $271,001
4 -21% $191,590
5 -13% $144,183

 The capital sum remaining after 5 years would be $144,183.

From these tables you can see that luck plays a significant part in how long your savings will last. For those that have retired from November 2007, they have unfortunately experienced one of the toughest periods in investment history in which to invest, and the future outlook remains equally uncertain.

The problem ?

Withdrawing money from your investments when markets are down often simply compounds the problem. Let’s imagine that you had $100,000 invested and markets fell by 40% as occurred with Australian shares during 2008 – you would have a balance left of $60,000. To meet your income needs you need to withdraw $10,000, leaving you with a balance of $50,000. To get your original capital back, you would need to get a return of 100% (ie another $50,000), whereas if you hadn’t drawn down the $10,000 you would only need to get a return of 66% (ie another $40,000 ) to get back to your starting point of $100,000.

The Solution

Whilst all of this sounds confusing, the underlying theme is clear; when you are approaching retirement you need to carefully consider your asset allocation, capital reserve and the amount you will be drawing each year from your investments.

To minimize the risk of the reverse compounding interest drawdown scenario outlined previously, it is generally recommended that prior to retirement, 3-4 years worth of drawings be held amongst the defensive assets. In addition to this, it is worth closely monitoring the drawdown level to ensure that it is broadly linked to income levels of the portfolio as a whole. This should enable you, as a retiree, to ride out even the most violent investment storm without unnecessarily destroying your hard earned wealth.

 If you have any questions in relation to your financial position please don’t hesitate to contact us at Main Street Financial Solutions – admin@mainstreetfs.com.au.

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Retirement Trap = Retiring in Periods of Poor Investment Returns
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Whilst no one has a crystal ball when it comes to predicting investment returns if you retire in periods of poor investment performance you could be in for a shock.
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Main Street Financial Solutions
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