Trending
“Play by the rules” and “be a good sport” were heard by many of us growing up. We typically use different terms as we get older, such as “ethical”, “honorable” and “treat others as we would want to be treated”. These words speak to how we should aspire to actwith other people, personally and professionally. These rules have not changed over the centuries even if adherence to these rules may have waned.
How does this apply to your wealth? It is very important that we play by the rules and make ethical choices. However, the rules are ever-changing throughout our life and some people don’t recognize these changes. If the rules for financial success change without you recognizing it, this may be very costly for you!
The I.R.S. tax code is a set of rules that changes often. Did your strategies change when the tax codes have changed? How did recent tax law changes affect you? Did your tax advisor consult you? How confident are you in knowing the impact of these changing rules on your wealth? Tax planning and tax mitigation may have a significant impact on your wealth and net rate of return. The rules don’t care if you are knowledgeable about them. The rules are just the rules, and the rule makers didn’t ask your opinion.
You also change some rules affecting your wealth based on your life decisions. During your employment years, your paycheck pays for your lifestyle as you save money in 401ks and other accounts for future retirement play-checks. During this period, your accounts are likely subject to Investment risk (stock market volatility) but a short-term stock market decline doesn’t likely affect your lifestyle. Your paycheck pays for your lifestyle. Your investment accounts are for days well into your future. You also have the risk of losing your job or your business failing.
For those near retirement or in retirement, you likely overcame the risks inherent during your working years (investment and employment risks). You may have accumulated enough financial resources and account values to walk away from employment and live your lifestyle funded by Investments, Social Security, Pensions, etc. This is the point in which you decide to change the rules for your game of wealth, possibly unwittingly.
In retirement, you must exchange your paychecks for play-checks from sources other than employment. You now have an income objective in retirement versus a growth objective for your savings and investment during employment. Efficient Income strategies are very different than growth strategies.
I believe the two most impactful risks during retirement are Longevity Risk and Sequence of Returns Risk. These risks are not likely impactful when your lifestyle is funded by paychecks and you are accumulating money while working. Let’s clarify these two risks based on moving from employment to retired.
Longevity Risk is the risk of outliving your money. While we may want to live a long, heathy life, this can stress your savings and investments. Becoming Old, Sane, and Broke is a risk as you no longer have employment income in retirement.
Sequence of Returns Risk is the order in which your investment returns occur and may adversely affect your account values when you are withdrawing money during retirement. This risk is less familiar to many and therefore, difficult to understand initially.
You likely make assumptions about the “average rate of return” you expect to earn from your portfolio. Let’s say your assumption is 6%. You do not earn exactly 6% every single year. This is true regardless of your assumed rate of return, it will not be linear! Investment risk leads to volatility and we all understand that there will be up years and down years in the stock market. Nobody can predict up years and down years in advance. Nobody.
Let’s review what can happen over a 25-year time period. A “negative sequence of returns” would mean you experience more of the down years early in the 25-year period and more of the up years later in that time period. A “positive sequence of returns” would mean the opposite.
-
While you are employed and accumulating wealth, without withdrawing, the sequence of returns is irrelevant. If you average 6% over the 25 years, it makes no difference when the up and down years are. You will accumulate the same amount of money as if you earned 6% linear every single year.
-
While you are retired and withdrawing money for your lifestyle, the Rules are very different. If you experience a negative sequence of returns (down years early on), these losses are compounded by your withdrawals and when future positive returns occur, your principle may not recover. This may lead to you running out of money despite earning a reasonable average rate of return like 6% or higher. Volatility in your portfolio is much more impactful when you are using your money versus leaving it alone to grow!