Why Reverse Dollar Cost Averaging Can Leave You Broke During Retirement?
“If you find yourself in a hole, stop digging. “ Will Rogers
Let’s look at the problem of “Figuring out how to set up your retirement accounts so you get the income you need and lower the risk of running out of money.”
First……. Let’s Review Dollar Cost Averaging
If you have a 401k at work, you are probably familiar with the term Dollar Cost Averaging.
For example. Let’s say you set aside $300 a month to go into your 401k. That $300 goes into your investment strategy no matter what, every month, like clockwork.
That means in periods when the market is up, your $300 buys less shares. In periods when the market goes down your $300 buys more shares. The hope is, over time, that you have a lower average cost of all your investments because you kept buying even when things were going down and were cheap.
It can be a really nice strategy for when you are in your 20’s, 30’s, 40’s, and 50’s to accumulate money over time.
So what the heck is Reverse Dollar Cost Averaging?
The exact opposite.
Now you are taking money out, on a systematic basis, (ie Retirement Income) and the fluctuations in the market can hurt you, instead of help you.
Imagine you are now 65 and retiring.
You are trying to figure out how to get income from your 401k, IRA and other accounts because you won’t be getting a steady paycheck anymore.
Read this Free MorningStar report to help you decide on a “Withdrawal” rate. Click Here.
Example. Let’s say you have $300,000 in your nest egg. You also decide to keep your money in the same types of mutual funds that you have right now and you will start taking out systematic withdrawals for your income needs.
The MorningStar study from above suggests you should start at a 2.8% withdrawal rate, but you decide they don’t know what they are talking about, and you decide to go with a 4% withdrawal rate.
So you start withdrawing 4% from $300,000, or $12,000 per year, as income from your IRA Mutual Fund allocation model.
If your mutual funds go up, this can work out really well. You are taking out income and your investments are growing.
The problem is, “What happens if your mutual funds go down?”
Don’t Take the Retirement Income You Depend On, From Investments That Go Up and Go Down
Example. Let’s say your mutual funds drop in value the first year by 20%, and your take out your 4% withdrawal.
At the end of year 1, your $300,000 is now only $230,400.
You lost 20% and you took out 4%
Taking out withdrawals in years that your account is down in value, accelerates the decline. It can set you on a death spiral where your only options are
- Continue Your Withdrawals and Possibly Run Out Of Money
- Reduce Your Income
- Stop Taking Income All Together
Any one of those can severely impact your lifestyle.
The other problem is, as your account goes down in value, the percentage of your withdrawal goes up if you keep your income the same.
Example: When you go to take out your $12,000 in year 2. The percentage is now 5.2%.
$12,000 from $234,400 is a 5.2% withdrawal.
Which is almost double the recommended withdrawal in the MorningStar research report.
You accelerate the decline and increase the odds of running out of money if you continue to take systematic income from accounts that are going down in value.
To paraphrase Will Rogers, you are in a hole, and you keep digging yourself deeper.
Why Use A Personal Pension Instead?
One option that is becoming more popular is setting up your own personal pension by using a portion of your IRA or 401k.
These are not affected as much by declining markets because you get a contractual guarantee that will provide steady income for life.
This will give you the confidence that
- You will not run out of money. You will get steady income for life.
- Market declines will not decrease your income
- Your principal is protected from market losses
Here’s a brief video that explains a popular type of Personal Pension and also gives some examples. Click Here For The Video.
If you are open to a phone conversation on how these types of plans work, and whether or not they might be a fit for you, give me a call at 847-376-8400.
Click here (Carl Ostenson) to see more of this author’s articles.
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My question is does dollar cost averaging in reverse in a rising market make sense? As compared to taking out a lump sum at the beginning or end of a calendar year. I thinking RMDs.