A key assumption in your retirement plan isthe average rate of return you expect toearn on your portfolio during the retirementyears. Of course, no one can predictwhat return various assets will provide over the next30 to 40 years. So with your financial planner, youreview the historical risk and return characteristics ofvarious asset classes and come up with the assumptionsthat go into making your retirement plan andmanaging your retirement portfolio. If you're likemost people, to be safe, you try to be somewhat conservativein making these assumptions.
Does this guarantee that if the average returns fordifferent assets over the years are just as you assumedand if you make withdrawals exactly according to yourretirement plan, you will not outlive your savings?
No. As a matter of fact, it is possible, even likely,that you will outlive your savings unless you areaware of the hidden risk of reverse dollar-cost averaginglurking in your retirement plan. Pay attention to itin both planning for retirement and managing yourportfolio during retirement.
What is reverse dollar-cost averaging? It's not a termyou hear very often, partly because people refer to thisrisk by various names and partly because most people,even most finance professionals, are not aware of it. Tounderstand what it is, let's start by reviewing dollar-costaveraging, which most physician-investors know about.
Dollar-cost averaging involves making yourinvestments in more or less equal periodic installmentsduring your savings years. One of the greatadvantages of this is that it takes the major guessworkout of investing. You don't have to guess—with a very high probability of being wrong—whenyou should get into and out of the market. Most ofus also realize that if we're disciplined about dollarcostaveraging, consistently investing even duringmarket downturns, in the long run, we can benefit.Investing during the down years gets us more assets(ie, number of shares) for the same money.
However, what most of us don't realize is that ifwe keep investing during the down years, in the longrun, we may end up earning a higher average returnon our portfolios than the average return on the marketover the same period. We can mathematicallyshow this to be true, although the amount of the additionalreturn will depend on how the market fluctuates.This happens because of the larger number ofshares we can buy in the market downturns for thesame amount of money.
For most of us, the dollar-cost averaging process isreversed during retirement. We sell assets and withdrawmoney more or less uniformly over time. Thisturns what was a benefit during the savings years intoa risk during the retirement years.
In traditional retirement planning, you implicitlypresume that stocks will earn the assumed returnsteadily, year in and year out. But in reality, the stockmarket goes through periods of sideways movementsor bear markets when prices get depressed and returnsare much lower than the long-term average, and thenthrough periods of bull markets with exuberant pricesand much higher than average returns.
So if you wind up unlucky and run into a bearmarket during the early years of your retirement andcontinue selling the same dollar amount of stocks, youwill have to sell a lot more stocks during those yearsbecause of the lower prices than your plan anticipated.Even if the stock market recovers in the later yearsand provides much higher returns, you may neverfully recover from the earlier damage because you willthen have much less money invested in stocks onwhich you will earn those higher returns.
Depending on how severe and long the early bearmarket is, following the traditional approach of sellingthe same dollar amount of stocks every year irrespectiveof market conditions can reduce the actual averagereturn on your stock investments by as much as half ofwhat you originally assumed. This is why you may endup outliving your savings or you may have to drasticallyreduce your expenses and withdrawals.
Two Redeeming Options
There are two ways to handle the risk of reverse dollar-cost averaging. The first is to recognize that you mayearn significantly lower average returns during retirementthan the market will. So you opt to save a muchlarger nest egg. If you're lucky and encounter a bullinstead of a bear market during your early years ofretirement, you may end up with some extra money thatyou can spend on some unplanned luxuries or leave forthe children and grandchildren. While this conservativeapproach to retirement planning is always advisable, fewof us can afford to save for a larger nest egg without significantlyreducing our current lifestyle.
The other approach is to avoid selling stocks duringretirement in a down market and sell more stocksthan immediately needed during bull markets. This isa more complex approach, and if mishandled, it mayend up increasing, not decreasing, the chance of outlivingyour savings. The obvious advantage is that youcan save less for retirement and your nest egg will gofurther. But if you want to take this unconventionalapproach, be sure that you really know what you'redoing or that you have a knowledgeable financialadvisor you can rely on.
Be prudent with your investing tools. Know whento hold steadfastly to them and when to adjust to yourlife stages. Don't let reverse dollar-cost averagingcause a reversal of fortune during retirement.
Chandan Sengupta, author of The Only ProvenRoad to Investment Success (John Wiley; 2001)and Financial Modeling Using Excel and VBA(John Wiley; 2004), currently teaches finance atthe Fordham University Graduate School ofBusiness and consults with individuals on financialplanning and investment management. He welcomesquestions or comments at firstname.lastname@example.org.