Sequence of Returns Risk: How to Protect Your Retirement from a Stock Market Crash

Casey Weade: The stock market takes a nosedive in retirement, and you're asking yourself, am I going to be okay? I'm going to give you one simple calculation today that will answer that for you. Hey, I'm Casey Weade, CEO and founder here at Howard Bailey Financial, also a certified financial planner practitioner. Today, we're going to talk about something called your retirement war chest. This is all giving you just a simple calculation to tell you if you're going to be okay, because you will encounter inevitable volatility in retirement.

When it comes to your stock market investments, they're going to be up, they're going to be down. The stock market does not move in a linear fashion. It's a bit of a roller coaster ride. Now you may not have all of your assets in the market and you shouldn't probably have all of your assets in the stock market when you're in retirement, but you still want to know when the market goes down, am I going to be okay? We're going to answer that question. Before we answer how to calculate that for yourself to figure out just how okay you actually are, I want to talk about the different places we can possibly invest those hard earned dollars of yours in retirement.

I'm going to do this using something that we like to call the three worlds of investments. Over here we have world number one. This is the fixed world of investments. In this fixed world, you know your principle is protected and it's probably backed by some type of legal reserve system. Think of things like treasuries, T-bills backed by the federal government. You have things like CDs or maybe bank savings accounts and money markets insured by the FDIC or you have insurance products like fixed annuities, for instance, or multi-year guaranteed annuities that all in this world provide you a fixed rate of return.

You know what your interest rate is going to be and they're all backed by some type of legal reserve system given that they are principle protected. Then you have the other end of the spectrum over there in that world of risk and that world of growth. Here you have your at risk investments, your stocks, your gold, your mutual funds, your real estate investments. We could fill up this whole whiteboard with all the different ways that you can take risk with your life savings. At the end of the day, all these assets are at risk.

Then we have this middle world. This middle world is somewhere between these two where you have returns that are tied to something in that world of risk. It could be the price of gold, could be the S&P 500, could be the Russell 2000. Your returns are going to be tied to something in that world of risk, but your principle is still going to be protected. Think of things like treasury inflation protection securities or tips that tie your rate of return to inflation. You could think of things like fixed indexed annuities.

You could think of things like equity linked CDs that are bank products, the issue CDs that tie your rate of return to that world of risk, albeit with some type of limit. Usually, you're getting a little bit more upside potential than if you took a fixed rate of return, but you're still principle protected at the end of the day. That's what's really important for this analysis is we want you to take a look and put a number to all the tools you have in this world. Add up all your cash, your fixed annuities, your indexed annuities, your T-bills, your tips. That's all of your principle protected dollars.

Add up all the other dollars that you have at risk, the real estate, the stocks, et cetera. Now, we have the numbers we need in order to answer this question for yourself. We answer it using something we call the retirement war chest. I drew a nice little chest over here. Don't judge me by my drawings, but I drew us a war chest over here. I wrote in there just a couple of words. This could be anything for you. This might be treasury bonds. This might be cash or money market. At the end of the day, what you're doing is you're adding up all of those dollars that you have in your war chest.

The money that you can go in the case of stock market is down, because what we're trying to avoid here is something called reverse dollar cost averaging. When the stock market's down, you don't want to sell, right? In retirement, you have a problem you didn't have in your working years, you need income. We need a place that we can go in order to supplement our income while you might be waiting for those stocks to rebound and recover so that you're not selling those things at a loss, running the risk out of running out of money. That's something that's also known as sequence of returns risk.

This is something that's very important that you always have a place you can go. If you're going to go ahead and continue to take risk with your investments in retirement, like most of the families that we work with for this scenario, we're talking about someone that has $400,000 in their war chest, about $300,000 in indexed world, about $100,000 in that fixed world. You got 400 grand and they need their investments to produce $3,500 a month. Now, we're not incorporating taxes or anything like that in here. You can factor that in.

If these dollars are in an IRA, you can go ahead and apply your effective tax rate to those dollars to reduce how much you might actually have effectively in your war chest to meet that $3,500. You could gross up the $3,500, for that matter, in order to come out with the number that you're looking for. In this scenario, they need $3,500 a month from their overall portfolio to supplement any other income streams they might have, social security, pension, whatever those other sources might be. Then we take that $400,000 war chest number, just divide it by how much we need every month. That comes down to 114 months.

This family has 114 months of dollars in their war chest in case something happens. They have nine years and six months that they could go without touching any of their at-risk investments. That's a pretty substantial war chest. Now you're asking yourself, well, how big should the war chest be? Should it be one year? Should it be five years? Should it be 10 years, 15 years, 20 years? Now I want to take you to some research that was done by our good buddy, Dr. Wade Pfau, over at Retirement Researcher, and walk you through how you might determine for yourself how big your war chest should be.

Some of the research and back testing in the S&P 500 that was done over at Retirement Researcher is really powerful, and I think it can help you really understand how much of a war chest you really need and what the long term really is because sometimes people will say, "Hey, I'm five years out from retirement," or you might say, "I'm 10 years out from retirement. Everything's going to be okay." That's the long term. Five years or ten years is what I usually hear as the long term. What we're talking about in the long term is how long do we have to stay invested in the stock market in order to realize those long term averages of 7% to 10%, that we still often hear.

These are the numbers going back to 1926. 1926 through December of 2022. We're looking at the holding period of one year all the way out to 60 years, and the best returns that you would have had over those periods of time. These numbers are annualized returns. Then the worst returns that you would have had annualized over those periods of time and the total range of returns. What I want to point out here is when we look at five years, we're getting a lot more stability at five years because now the best returns, 36% annualized, but the worst return is negative 17% per year versus at three years, negative 42%, one year, negative 68%. That tells us the long term is definitely longer than five years.

I really prefer, and this is all coming down to your own personal risk tolerance, but we often are big proponents of building about a 10 year war chest. That's really because of the numbers. At 10 years, we start to see that we're getting a lot closer to seeing that negative 5% return. Then if we get out to 15 years, now we're going, okay, throughout any time period in history over a 15 year period, at least I would have broke even over that 15 year period. We really need 20 or 30 years as the data is showing us, arguably really 30 years is what we need in order to have a pretty, really high degree of confidence that we're going to get those numbers in that 7 to 10% range.

However, it's up to your own risk tolerance. I have worked with people that want a 12 month war chest all the way out to a 20 year war chest. You have to answer that number for yourself and let's take a look at a few different scenarios using different war chest numbers. Now, we're taking a look at three different war chest examples and we go back to that first one. We had someone that's spending $3,500 a month and we're going to spend $3,500 a month out of our investments in all three of these examples so that we can get the concept.

When it comes to this one, we had $100,000 in the fixed bucket, about $300,000 in the index bucket. They ended up with $400,000 war chest divided by 3,500, 9 years and 6 months is their war chest. When it comes to our next example, we have someone that wanted to keep 12 months of cash in the bank. They have $42,000 in cash, about $420,000 in bonds, that gives them a $462,000 war chest, about an 11-year war chest.

Then we have someone that wanted to keep $42,000 in money market and about 200 grand in treasury inflation protection securities, $252,000 in their war chest divided by 3,500. Now, they have a 6 year war chest. Your war chest is going to be unique to you and unique to your income strategy in retirement. If you want a free income analysis and to have us start to build your own retirement war chest, just call the number on your screen and schedule a time to visit with one of our fiduciary financial planners.

[00:10:22] [END OF AUDIO]