Most people assume that if their retirement plan says they’re going to be okay, they’re going to be okay. But what happens if the market drops 30% tomorrow? I recently reviewed a plan that showed just how much that timing can matter.
The retiree, whom I’ll call Ben, had a $2 million portfolio. With a projected 6% annual return and $100,000 in yearly retirement spending, his original plan showed $454,000 remaining at age 90.
Then we made one change. We assumed Ben retired into a major market decline, followed by a recovery. Over his retirement, the average return was still 6%. But now Ben ran out of money at age 86. By age 90, the projection showed a $485,000 shortfall.
Same starting savings. Same spending. Same assumed average return. A completely different outcome.
Why the order of investment returns matters
This is called sequence-of-returns risk. While you’re working, a market decline can be frustrating, but your paycheque keeps coming in. You can keep saving and investing. Retirement is different. Now your portfolio has to pay the bills.
Imagine a $2 million portfolio falls 30%. It is now worth $1.4 million, before accounting for any withdrawals. If you continue withdrawing money while markets are down, fewer dollars remain invested to participate in a recovery. Even if the average return over the entire period looks reasonable, the timing of losses and withdrawals can leave you with less money.
That’s why a retirement projection showing the same return every year doesn’t tell the whole story. Ben’s numbers are specific to his plan, but the problem they reveal is one every retiree needs to think about.
But Ben already owned conservative investments
Now you might be thinking, why didn’t Ben just take money from his conservative investments while stocks recovered? That’s a fair question.
Ben had a balanced portfolio, not an all-stock portfolio. The challenge was how his investments were organized. When stocks and bonds are held together in a single balanced fund, selling units to generate income generally means selling a proportional share of both. That can include stocks after a substantial decline.
I’m not suggesting balanced funds are bad investments. The issue was that Ben didn’t have a separate pool of money set aside for spending. When he needed income, he was selling from the whole fund, including investments that had fallen.
The bucket strategy gives retirement money different jobs
When I review a retirement plan, my first question isn’t how to make the projected return higher. It’s where the income will come from if markets struggle for several years.
That’s where the bucket strategy comes in. I like to think of retirement money as having different jobs. The money you need next year has a very different job from the money you won’t need for another 15 or 20 years.
Bucket one: money for near-term spending
This is money intended to cover the next few years of planned withdrawals. Depending on the situation, it might include cash, high-interest savings accounts or short-term GICs. Its main job is availability, not growth.
Bucket two: money for the middle years
The second bucket covers the middle years. It sits between the money you’ll spend soon and the investments you want to leave alone for longer. Its job is to help bridge that gap.
Bucket three: money for long-term growth
The third bucket is for long-term growth. This money can stay invested to help fight inflation and fund the later years of retirement. It will still go up and down with the markets, and that’s expected.
Of course, you still need a plan for when and how to refill those buckets. This approach doesn’t eliminate market risk or guarantee a better outcome. What it does is give each part of your portfolio a clear purpose.
What changes when the market falls?
Now imagine Ben had set aside the next few years of spending before he retired. When markets fell, his growth investments would still fall. But he wouldn’t need to rely on those investments for next year’s income. He already had money set aside in his first bucket.
And that’s really the benefit of the bucket strategy. It’s not that markets behave differently. It’s that you behave differently. Instead of wondering what to sell when markets are down, you can follow a plan that was built for difficult stretches. You’re not predicting a crash. You’re preparing for one.
For more on the mechanics, see our article on avoiding withdrawals when investments are down.
Retirement planning is also income planning
One of the biggest mistakes I see financial advisors making is treating retirement like an investing problem. It’s partly an investing problem, but it’s also an income problem. And those aren’t necessarily the same thing.
The portfolio that got you to retirement probably isn’t the same one that should get you through retirement. Your plan needs to answer more than “How much do I need?” It also needs to answer where your income will come from when markets don’t cooperate. So here’s the question I’d leave you with: If the market does come down 30 or 40% tomorrow, where would the next few years of your spending come from?
The Atlas System is how we look at these decisions together, including income, investments, taxes and estate planning. And once your investments are organized, it is also worth looking at the tax side of withdrawals, including the RRSP meltdown strategy.
For general guidance on matching short-term savings with accessible investments and long-term savings with appropriate risk, see the Financial Consumer Agency of Canada’s investment guidance.
These examples are for educational purposes. The assumptions, withdrawal needs, taxes and investment results in an individual retirement plan will vary.
