Many people use retirement accounts, like 401(k)s and individual retirement accounts (IRAs), to save for retirement. These accounts let you invest money for the long term and give you tax advantages. However, investing in this way means that your retirement savings are subject to stock market volatility. If you’re concerned about how stock market volatility will affect your retirement savings and how you can protect your portfolio against it, here’s what you need to know.
How Stock Market Volatility Affects Retirement Savings
When you invest money in the stock market, you’re doing so in hopes that your investments will gain value. On average, over time, you’re likely to make money in the stock market. The S&P 500 has, on average, returned just under 10% per year over the last near-century. However, the index’s best year posted returns of almost 50%, and its worst year saw a drop of about 37%. If a 37% drop were to happen the year before or after you retire, it could have a massive impact on your retirement plans. The 4% rule states that you can safely withdraw 4% of your starting portfolio value each year in retirement, adjusted for inflation. If you started with a portfolio of $250,000, that means you could withdraw $10,000 per year in retirement. However, if your portfolio drops by 38%, you’d only be able to withdraw $6,200 per year, reducing your monthly income by more than $300. Young people can weather this volatility, because they have plenty of time before they retire and can wait for returns to average out. However, people who are close to retirement should take steps to reduce their portfolio’s volatility.
Preparing Your Portfolio for Volatility
There are a few ways to reduce the volatility of your portfolio. One is to adjust your asset allocation, which is the mix of different securities in your portfolio. Stocks tend to be more volatile than other assets, such as bonds. As you near retirement, you can reduce the amount of money you have invested in stocks and place more in bonds. You can also try to increase your diversification among different stocks. If you’re heavily invested in one business or industry, you may experience more price movement than if you were to spread your investments across many different stocks. Some investors nearing retirement also choose to keep more cash on hand. They can live off the cash when the market is down, giving them a chance to wait until the market begins to rise again.
How To Protect Your 401(k)
Your 401(k) is a benefit that may be offered by your employer. Typically, you won’t have full control over the investment options in your 401(k). Instead, you’ll have to choose from a menu of investment choices offered. This can limit your ability to reduce volatility in your 401(k), but most employers will offer some type of bond mutual fund in their 401(k) plans. You can also hold cash in your 401(k), typically in a money market fund.
How to Protect Your IRA and Self-Directed Savings
If you have an IRA or a taxable brokerage account you’re using to save for retirement, you have more flexibility than you do with a 401(k). While many people invest in mutual funds in their IRA, much as they do in their 401(k), there are other options available. You’ll be able to choose from almost any mutual fund or even decide to move money into individual savings bonds, certificates of deposit, or other securities. If you choose to invest money into a less-volatile, fixed-income asset like a bond or a bond mutual fund, there are a few things to pay attention to. Primarily, you’ll want to look at the interest rate, bond ratings, and fees. Because you have more flexibility in an IRA, you can shop around to find a mutual fund provider that has a bond fund with a low expense ratio.
Planning for Retirement in Volatile Times
Sequence-of-returns risk is one of the top risks facing retirees. A bad year for the market in the years immediately preceding or after your retirement can have a significant, negative impact on your retirement’s success. Investors need to have a plan to respond to poor market performance. If you’re still working, the simplest solution may be to work an extra year or two while the market recovers. Doing so has the added bonus of letting you save even more money for retirement. Another strategy to mitigate sequence-of-return risk is to reduce your withdrawals in down years, forgoing some discretionary expenses, such as vacations. Some retirees choose to purchase annuities to avoid this risk. Annuities offer guaranteed income in exchange for an upfront payment. However, one drawback is that you won’t be able to leave the annuity behind to heirs in the way you could bequeath remaining retirement savings. You can also fight this risk by increasing your cash holdings in the years leading up to retirement and drawing from that cash cushion if the market begins to fall during the early years of your retirement. That would let you keep more money invested until the market begins to rise again.
The Bottom Line
Investment volatility is one of the top risks facing retirees. One bad year can have a serious impact on the quality of your retirement. However, taking some basic steps, like diversifying your portfolio and moving money to more stable investments, can help you reduce this risk.
