Why Average Returns Can Mislead Your Retirement Plan

The Problem With Average Returns

Consider a retiree who begins retirement at age 60 with $500,000 in investable assets. The objective is to use the portfolio to help provide income over the next 30 years.

In the first scenario, the portfolio earns a steady 8% return every year. There are no major declines or unexpected market events. The portfolio is gradually drawn down and is designed to last until approximately age 90.

In the second scenario, the portfolio also averages 8% over the full period. However, the returns do not arrive in a straight line.

The portfolio loses 20% during the first year of retirement and another 5% during the second year. Stronger returns occur later, bringing the long-term average back to 8%.

Although both retirees earned the same average return, the second portfolio runs out at approximately age 78.

The average return was the same. The outcome was not.

Why Early Market Losses Matter

Market declines can be easier to manage while you are still working and contributing to your investments. You may continue purchasing investments at lower prices and give the portfolio time to recover.

Retirement changes the situation.

Instead of adding money to the portfolio, you are withdrawing from it. If markets decline early in retirement and you still require income, you may be forced to sell investments while their values are down.

This leaves fewer dollars invested when markets eventually recover.

For this reason, the first five to ten years of retirement can be especially important. A poor market year at age 88 may still be uncomfortable, but much of the retirement journey has already occurred.

The same decline at age 61 or 62 can affect the entire retirement income plan.

Retirement Income Planning Is Different From Investment Management

Investment management asks:

How should the portfolio be invested?

Retirement income planning asks:

How can the portfolio provide reliable income without creating unnecessary risk?

These questions are related, but they are not the same.

A portfolio that may be appropriate for someone who is still working may not be structured properly for someone who is retired and withdrawing income.

The investments may be similar, but the portfolio may need to be organized differently because its purpose has changed.

The goal is no longer only to accumulate wealth. The portfolio must now help fund retirement.

How a Cash Wedge Can Help

A cash wedge, also known as a cash flow wedge, involves setting aside part of the portfolio in more stable and predictable investments.

The purpose is to provide retirement income without forcing the retiree to sell longer-term investments during a market decline.

For some retirees, this may mean keeping one to three years of retirement income in a more resilient portion of the portfolio. The appropriate amount depends on the individual situation.

The objective is to create a reliable source of short-term income while giving the remaining investments time to recover from market volatility.

This can also reduce the risk of panic selling. A retiree should not have to sell investments at a loss simply to fund the next retirement paycheque.

Questions to Ask Before Retirement

A retirement income plan should consider more than an assumed average rate of return.

Ask yourself:

• How much of my retirement income must come from my investments?
• How flexible are my withdrawals if markets decline?
• Am I relying only on an average return assumption?
• Do I have a clear withdrawal strategy?
• Could poor returns during the first five years change my retirement outcome?
• Would I know what to do if markets declined shortly after I retired?

The worst time to develop a strategy for a market decline is during the decline itself. Emotions are often higher, confidence may be lower, and investors can be more likely to make decisions they later regret.

Timing Matters in Retirement

Average returns can make a retirement plan appear successful on paper while hiding the effect of early market losses.

The order in which returns occur can be the difference between a portfolio that lasts and one that runs out too early.

A strong retirement income strategy should provide more than an attractive projected return. It should offer reliable income, flexibility, and the confidence to remain disciplined when markets become uncertain.

Watch the video below to learn more about sequence of returns risk and how a properly structured retirement income strategy can help protect your portfolio.