When you are withdrawing retirement savings, timing is everything.
If you are in the pre-retirement or retirement phase of your life, you have a lot to consider when it comes to your future finances. Beyond government and company-sponsored pension plans that will provide you with income during your retirement, it is important to ensure that your personal investments will last to supplement these sources and provide the lifestyle you desire and deserve. If you are fortunate enough to have a generous defined benefit pension plan funded by your employer, then for the most part, your future income is secure. But if you are like the 60 per cent of Canadians who won't enjoy a guaranteed income stream from a former employer, the decisions you make about how to invest your nest egg - especially a few years before and a few years after retirement - could have a significant effect on your retirement lifestyle.
WHAT'S KEEPING YOU AWAKE AT NIGHT?
When it comes to financial planning, a number of issues can affect the income that is available to you in retirement. What follows is a brief overview of the main financial concerns you should discuss with your financial advisor.
LOSING MONEY TO THE MARKETS
Losing money because of poorly timed investment decisions or market volatility tops the list, since many people find that money, once lost, can be very difficult to replace. This is especially true if you have already left the workforce or if your health no longer allows you to work.
Perhaps the best way to avoid losing money is to pay close attention to the asset allocation of your portfolio - specifically, the percentage of your investments that are:
- Stocks
- Bonds
- Cash (including treasury bills and GICs)
If your portfolio is heavily invested in stocks, you may be too exposed to the volatility of the financial markets and run the risk of losing your capital permanently. This is especially true if you have selected investments in highgrowth areas, such as commodities or emerging markets.
To ascertain the overall risk level of your portfolio, you should seek the advice of an experienced financial advisor. He or she can provide you with an analysis of your asset allocation and recommend changes based on your current age, your need for investment growth and your tolerance for risk.
WATCHING INFLATION ERODE SAVINGS
After a number of years of low inflation, price increases are once again on many economists' minds. Income received from the Canada/Quebec Pension Plan, Old Age Security and a select few (mainly government) company pension plans are indexed to inflation, but beyond this many investors must plan to compensate for the effects of inflation on their own. Even at low levels, inflation reduces your purchasing power over time. For example, an inflation rate of one per cent over 25 years reduces the value of $1,000 to $780; at two per cent the value drops to $610, and at three per cent the value drops to $478. These numbers help to illustrate the importance of choosing investments that have the potential for long-term growth so your income can grow, too.
BURNING THROUGH YOUR MONEY TOO FAST
There are many ways to run out of money - especially if you do not allow for growth in your investment portfolio. Unfortunately, many retirees do not properly assess how much money they'll need to withdraw annually from their personal savings, or plan for financial emergencies. This often leads them to withdraw money at rates that are unsustainable over the long term.
IMPORTANT: The projections or other information generated by this analysis regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. The simulations are based on a number of assumptions. There can be no assurance that the projected or simulated results will be achieved or sustained. Results may vary with each use and over time. The chart presents only a range of possible outcomes. Actual results will vary, and such results may be better or worse than the simulated scenarios. The potential for loss (or gain) may be greater than demonstrated in the simulations.
Material Assumptions: T. Rowe Price has analyzed a variety of retirement savings strategies using computer simulations to determine the likelihood of "success" (having at least $1 remaining in the portfolio at the end of the retirement period) of each strategy, shown as percentages. The analysis for each retirement strategy is based on running 100,000 hypothetical future market scenarios that account for a wide variety of return possibilities. The initial withdrawal amount is the percentage of assets withdrawn at the beginning of the first year of retirement, is a lump sum made at the beginning of each year, and is inflation-adjusted (three per cent) annually. Investment scenarios are based on hypothetical (not historical) annual rates of return for the three asset classes represented in the portfolio mixes. The return assumptions of 10.00 per cent for stocks, 6.50 per cent for bonds, and 4.75 per cent for short-term bonds are based on T. Rowe Price's best estimates for future long-term periods. The expense ratios for the asset classes are stocks 1.211 per cent, bonds 0.726 per cent, and short-term bonds 0.648 per cent. These examples only present a range of possible outcomes. T. Rowe Price's annual return assumptions take into consideration the impact of reinvested dividends and capital gains. Investment expenses in the form of an expense ratio are subtracted from the expected annual return of each asset class. Taxes are not taken into consideration, and no early withdrawal penalties are assumed. Investment expenses in the form of an expense ratio are subtracted from the expected annual return of each asset class. These expenses are intended to represent the average expenses for a typical actively managed fund within the peer group for each asset class modelled. The analysis does not take into consideration all asset classes, and other asset classes not considered may have characteristics similar or superior to those being analyzed.
The previous chart may help you estimate a sustainable percentage of your portfolio that you can withdraw as income every year, based on its asset allocation. Since every person's situation is unique, you should speak with your financial advisor about how this estimate applies to your own circumstances.
Using the third column in this chart as an example, we can see that an investor with a portfolio of 60 per cent stocks and 40 per cent bonds who withdraws five per cent of his or her retirement savings each year enjoys a 63 per cent chance that the portfolio will last for 30 years. If the investor raises the annual withdrawal rate to eight per cent, the chance the portfolio will last 30 years drops to just eight per cent.
Many Canadians allocate a large percentage of their savings to guaranteed investments, such as bonds or GICs. The problem with this approach in today's markets is that traditional interest-bearing investments pay very little in the prevailing low interest rate environment. What's more, these investments are the least tax-efficient. This means that the after-tax return you will likely receive will barely keep up with the rate of inflation.
As you can see, a very conservative portfolio (20 per cent stocks, 80 per cent bonds) has only a 40 per cent chance of lasting 30 years at a five per cent withdrawal rate. This is why the asset allocation of your retirement portfolio needs to be discussed in detail with your financial advisor. The safety of your principal investment is important, but so is the potential to grow your investment over time and ensure that your income keeps pace with inflation.
IN THE RETIREMENT RISK ZONE, TIMING MATTERS
Investors face two major challenges when they invest for retirement. If they invest too conservatively, they may not achieve the rate of return they need to grow their savings sufficiently to meet their long-term needs and beat inflation.
On the other hand, if they invest too aggressively, they run the risk of losing valuable capital at a time when they can least afford it. The fact is, a poorly timed investment decision - or even an extended period of market volatility at the wrong time - can severely undermine even the most well-thought-out financial plan.
Research demonstrates that the financial risks retirees face are very real. A downturn in the markets during the few years before retirement has the potential to reduce savings to a level that won't provide sufficient income. What's more, there may not be enough time for the markets to help pre-retirees recover their losses before they finish work.
If the same market decline occurs during the first few years after you start retirement, while you are withdrawing income regularly, the impact can be significantly more detrimental to your retirement plans.
We call this window - the time period just before and just after you retire - the retirement risk zone. The events that take place during this time can have a profound effect on your retirement lifestyle. In other words, the retirement risk zone is the period of time when you are most vulnerable to the volatile nature of the financial markets.
COMPOUNDING CAN WORK AGAINST YOU LATER IN LIFE 
When you are accumulating wealth, perhaps the best determinant for long-term success is time in the market. The longer you remain exposed to a well-diversified portfolio of investments, the better your opportunity to achieve your financial goals. The reason is simple: compound investment returns can be highly effective at building wealth over time.
The following example illustrates this clearly. In this scenario, we have two investors, Phil and Anne, who each start with $30,000 and remain invested for 25 years. You'll notice that the investment returns for Phil and Anne are different. Phil begins with poor early returns that rise over time, while Anne receives strong early returns that decline over time.
Even though Phil and Anne receive their investment returns in reverse order, they still manage to achieve the same average: eight per cent annual return over 25 years. As a result, both Phil and Anne end up in exactly the same place. In this scenario, where the goal is wealth accumulation, the order of investment returns does not affect the final outcome. The lesson to be learned is the importance of remaining invested over time.
1 Returns are hypothetical and not actual returns. The sequence of returns has an average compounded annualized return of eight per cent over 25 years and year-to-year volatility that is consistent with a portfolio predominantly comprised of stocks. The accumulation phase portfolios assume a starting value of $30,000 at age 40 and no annual withdrawals. The retirement phase portfolios assume a starting value of $206,049 at age 65, as well as a five per cent first-year withdrawal thereafter adjusted for three per cent inflation annually.
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The situation changes dramatically when it's time to begin making withdrawals. During this critical period, historical long-term average returns won't allow you to forecast accurately how long your money will last. The reason is that if you are withdrawing money from a portfolio that is suffering from a series of early losses, the effect of compounding works in reverse. In other words, compounding works for you during the accumulation phase, when you are trying to save money, but can work against you when you need to withdraw money for retirement. Let's look at the potential impact of this problem on Phil and Anne's retirement savings. If we carry over the investment values from the previous chart, let's assume that Phil and Anne each have $206,049 at the beginning of their retirement and need to withdraw five per cent, or $10,302, per year, adjusted to account for an inflation rate of three per cent, to help fund their retirement. Both receive the same eight per cent average annual rate of return over a 25-year period. What differs is the order of investment returns - which the two investors experience, once again, in reverse order.
| Difference in Withdrawals $208,285 |
Difference in End Value $793,304 |
Total Difference $ 1,001,589 |
Phil suffers routine losses after he begins withdrawing money to fund his retirement. Even though his portfolio's returns remain largely positive for the subsequent 13 years after that, he still runs out of money within 14 years. What's more, the total amount of income he withdraws over the time period adds up to less than his principal investment. Anne is much more fortunate. During the first few years, Anne's portfolio performs well and earns some exceptional returns. Even though she continues to make the same withdrawal amounts as Phil, the value of Anne's portfolio continues to grow. Using this scenario, Anne will have the enviable choice of either increasing the amount of income she receives during retirement or leaving a larger estate for her beneficiaries. When you look at the total variation between their investment values after 25 years and the amount of withdrawals during the period, Anne ends up enjoying over $1 million more than Phil, due simply to the sequence of returns her portfolio experiences. As we can see from this example, two investors who receive identical, average rates of return over a period of time face dramatically different outcomes. The only difference between Phil and Anne is timing. It goes to show you how an illtimed portfolio decline within the retirement risk zone can deplete your savings sooner than you might expect. |
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YOUR ADVISOR CAN HELP YOU NAVIGATE THE RETIREMENT RISK ZONE
For many Canadians, investing for retirement feels like a tightrope walk between investing conservatively and investing for continued growth. It's human nature for people to want to protect their savings from the volatile nature of financial markets - but not allowing your savings to grow carries its own risks as well. By attaining a deeper understanding of these risks, you will be better informed so you can take the steps necessary to enhance your financial plan. Even though Anne continues to make the same withdrawal amounts as Phil, the value of Anne's portfolio continues to grow.
If you are concerned about whether your financial plan takes these investment challenges into account, speak with your financial advisor. He or she is a trained professional who can help you navigate your way through the retirement risk zone and achieve your financial goals. Start with a careful examination of the asset allocation of your own investment portfolio. Also, look for investment products that help protect your investments from potential perils in the retirement risk zone, but still allow your portfolio to grow and eventually provide steady, guaranteed income.
Note: For more information about the retirement risk zone and new investment strategies to address this risk, ask your advisor for a copy of the Winter 2006 edition of Solut!ons magazine later this year.
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