Retirement Income Planning Risks – Reverse Dollar Cost Averaging
Retirement income planning is a balancing act to find the optimal allocation of assets for growth, and separately, for income.
Assets that perform well for growth are a key part of the puzzle, as they will protect you from risks like inflation, but they should not be relied upon for growth.
Likewise, assets designed for income do their job, but are not likely to offer you growth.
Using the wrong tool for the job can not only give you mediocre results, but it can actually increase and magnify your overall risk.
Sadly, many retirement investors just don’t ‘Get It’ and they sabotage themselves chasing one magic silver bullet after another looking for a one size fits all solution.
Worse still, a lot of retirement income planners don’t know how to do it the right way either… how to allocate the right amounts and solve for the right questions.
Far too often, the mainstream advice is to ‘buy and hold stocks’ or ‘buy low-cost index funds’. These are great growth strategies, but when the same old advice is offered up as retirement income planning, the results are disastrous.
Today, I wanted to share with you a paper that I dug out of the archives because it presents an extremely valuable lesson for people transitioning from accumulation mode and into preservation and income maximization mode. It’s useful for anyone thinking about withdrawing investment assets for retirement income.
…And really, that means everyone…
Most people understand the benefit of dollar cost averaging during the saving years. Few people realize, however, that those exact same principles work against you when taking income from your nest egg.
The result is a phenomenon called reverse dollar cost averaging. And you expose yourself to this risk by using the wrong tool for the job. If you are clinging to a stock portfolio and using a drawdown strategy like the ‘4% rule’ for selling assets to generate retirement income, you are shouldering significant risks.
Let’s take a look at the problems this could potentially cause and some possible solutions.
This study was completed by Henry K. Hebeler in January of 2001 and can be found here. It is a quick read with a very important thesis…
In the author’s words:
“The long term effect is that retirees get less out of their investments than historical rates might suggest, because they take money out on a regular basis, and the periodic withdrawals in a low market leaves permanent damage.”
“The message is loud and clear. The returns for retirement planning are far too high for a retiree who wants a fair chance of financial survival.”
Why is this? Please allow me to paraphrase some of the information.
The principle of dollar cost averaging shows that buying a large number of shares at low prices when the market is down more than offsets the cost of buying fewer shares at higher prices when the market is up.
This leads to greater than average returns over the long run and offers a major advantage to systematic savers.
All major financial institutions have marketed this to the maximum extent to teach consumers the value of regular investment contributions and long-term strategies.
But there is another side to this story. For every buyer of securities, there must be a seller or as Hebeler puts it,
“for every winner, there is a loser.”
The loser, in this case, is the person selling stocks for income purposes. Selling stocks systematically presents the exact opposite effect on long-term returns, also known as reverse dollar cost averaging.
Over time, returns for buyers and sellers will average out. There’s no win/win. Historical data proves that regular withdrawals produce less than average returns just as regular deposits produce higher than average returns.
This presents a major challenge for advisors and consumers who are looking to manage assets for the traditional 4% annual retirement income withdrawal.
Yes, it is, and it’s surprisingly simple…
All you have to do is separate income assets from growth assets in order to optimize your portfolio throughout retirement.
- Invest your Growth portfolio for Growth, and not Income… And rely on it for growth, opportunities, and flexibility.
- Invest your Income portfolio for Income and not Growth… And rely on it for daily living expenses, baseline needs, and your general cost of living.
And further, it is an actuarial fact that an income portfolio cannot be truly optimized without a source of guaranteed, lifetime income… in order to eliminate longevity risk from the equation entirely.
When your retirement income source is insured and stable, you can more easily afford to ride out low points in the market. If you know that your paycheck is guaranteed no matter what happens, you can and should wait to sell shares when the market returns to normal levels.
This is an important lesson because you need to be prepared for every opportunity to do better than average.
Guaranteed income does, in fact, offer far more benefits than just guaranteed income.
Read that one again…
As crazy as that sounds, it’s an actuarial, mathematic and economic fact, as illustrated in Hebeler’s study. Putting guaranteed income in place frees your remaining growth portfolio up to remain focused on growth. This is the ultimate inflation hedge, as well as simply prudent planning.
I’ll do more in the future to drive this point home.
Are you interested in protecting yourself from the phenomenon of reverse dollar cost averaging? That should now be an easy question to answer.
Call, email or make an appointment now to give yourself every possible advantage for a solid retirement income plan.
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