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Putting Your Nest Egg in Three Baskets

“You can’t time the market” is an old maxim, but you also might say, “You can’t always time retirement.” Only 46% of current retirees say they retired when planned, while 48% retired earlier than expected.1

Taken together, these two uncertainty factors suggest that it would be wise to prepare for the possibility that you might retire during a market downturn. You’re fortunate if you retire during a market upswing.

Sequence Risk

The risk of experiencing poor investment performance at the wrong time is called sequence risk or sequence-of-returns risk. All investments are subject to market fluctuation, risk, and loss of principal — and you can expect the market to rise and fall throughout your retirement. However, market losses on the front end of retirement could have an outsize effect on the income you might receive from your portfolio.

If you’re forced to sell investments during a downswing, you may reduce your portfolio’s potential to benefit when the market turns upward. Those who retired around the time of the Great Recession faced this situation. The market ultimately came back strong, but it took more than five years to reach the pre-recession high.2

U.S. Stock Market annual returns: 1991=30.4%. 1992=7.62%. 1993=10%. 1994=1.3%. 1995=37.5%. 1996=23%. 1997=33.3%. 1998=28.5%. 1999=21%. 2000=minus 9%. 2001=minus 11.8. 2002=minus 22%. 2003=28.6%. 2004=11%. 2005=5%. 2006=15.7%. 2007=5.4%. 2008=minus 37%. 2009=26.4%. 2010=15%. 2011=2%. 2012=16%. 2013=32.3%. 2014=13.6%. 2015=1.3%. 2016=12%. 2017=21.8%. 2018=minus 4.3%. 2019=31.4%. 2020=9.74. 10-year average annual returns: 1991 to 2000=17.4%. 1996 to 2005=9%. 2001 to 2010=minus 0.07%. 2006 to 2015=7.3%. 2011 to 2020=13.5%.

Dividing Your Portfolio

One strategy that may help address sequence risk is to divide your retirement portfolio into three different “baskets” that provide current income, regardless of market conditions, and growth potential to fund future income. The starting point for this approach is to determine the annual income you need from your portfolio, after other sources such as Social Security or a pension.

As with any withdrawal method, it’s important to be realistic. Although this method differs from the well-known “4% rule,” an annual income around 4% of your original portfolio value might be a reasonable starting point, with adjustments based on changing needs, inflation, and market returns.

Basket #1: Short term (1 to 3 years of income). This basket holds stable liquid assets such as cash and cash alternatives that could provide income for one to three years. Having sufficient cash reserves might enable you to avoid selling growth-oriented investments during a down market, which would lock in losses and may reduce the income from your portfolio over your lifetime.

In the current low interest-rate environment, these assets will generate little or no return, so you are trading potential growth for stability. You might further divide this basket between cash to cover one year of expenses and relatively stable low-yield assets, such as short-term bonds, that may offer a small return and can be sold to cover an additional year or two of expenses.

Basket #2: Mid term (5 or more years of income). This basket — equivalent to five or more years of your needed income — holds mostly fixed-income securities such as intermediate- and longer-term bonds that have moderate growth potential with low or moderate volatility. It might also include some lower-risk, income-producing equities.

The income from this basket can flow directly into Basket #1 to keep it replenished as the cash is used for living expenses. If necessary during a down market, some of the securities in this basket could be sold to replenish Basket #1. These securities could then be replaced with funds from Basket #3 when the market rises again.

Basket #3: Long term (future income). This basket is the growth engine of the portfolio and holds stocks and other investments that are typically more volatile but have higher long-term growth potential. Income from these assets can flow directly to Basket #1, but the most important role of Basket #3 is to generate investment gains to replenish both of the other baskets. In a typical 60/40 asset allocation, you might put 60% of your portfolio in this basket and 40% spread between the other two baskets. Your actual percentages will depend on your risk tolerance, time frame, and personal situation.

Preparing in Advance

With the basket strategy, it’s important to start shifting assets before you retire, at least by establishing a cash cushion in Basket #1. The appropriate time to do this depends on your situation and the market environment. Moving too large a percentage of your investments into cash far in advance may not be wise, but waiting too long could expose you to the same sequence-of-returns risk you are trying to avoid.

There is no guarantee that putting your nest egg in three baskets will be more successful in the long term than other methods of drawing down your retirement savings. But it may help you better visualize your portfolio structure and feel more confident about your ability to fund retirement expenses during a volatile market.

Asset allocation does not guarantee a profit or protect against investment loss. The principal value of cash alternatives may be subject to market fluctuations, liquidity issues, and credit risk. Bonds redeemed prior to maturity may be worth more or less than their original cost. Investments seeking to achieve higher yields also involve a higher degree of risk.

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