Investors withdrawing money from their portfolios are often concerned about the probability of ruin, where ruin is defined as the depletion of the portfolio prior either to a fixed date, or to a random date such as the end of retirement (i.e., the end of a lifetime). Investors worry about a portfolio’s ability to support a desired level of consumption, like a child’s college expenses or a minimum standard of living throughout retirement. The market turmoil that has characterized the first years of the 21st century has heightened fears regarding the ability of some retirement portfolios to meet long-term financial objectives.
“During periods of substantial decline in market values, the reserve acts as a source of income replacement as portfolio withdrawals are trimmed or, in the extreme, eliminated. However, during periods of portfolio surplus, the reserve must be restored.”
This essay provides insights into several issues:
- Does a 35% drop in a retirement portfolio’s value translate into a 35% drop in expected future retirement income?
- How should “rainy day” funds be designed and implemented?
- What moderate course corrections can retirees take now to avoid draconian corrections at a later date?
Among the myriad of investment advice books and articles, one often finds admonitions to establish a reserve fund. Although almost everyone agrees that a reserve fund is a good idea, there seems to be much ambiguity surrounding its funding level and intended uses. The commonplace meaning of a reserve account for individuals is an emergency fund, a rainy-day fund, or some similar moniker. As the names imply, investors contemplate using the fund to soften economic shocks to income (unemployment), to tangible assets (home repairs), or for other untoward events (health emergencies).