Consider an investment portfolio that has grown up to $10,000 before experiencing a decline in value down to, say, $7,000. The drawdown amount in this scenario would be $3,000, or a crushing 30% of the peak value -meaning that the portfolio has lost 30% of its value before potentially recovering. Situations like this happen, and it's why understanding the implications of drawdown periods on retirement planning and learning how to recognize and manage them can make a big difference between securing your financial future and facing frightening uncertainty. At PensionBee, we want to help you be retirement confident - and learning about drawdowns can help you get there.
Important Note:
- This article is about investment drawdown and should not be confused with "drawdown percentage" which is a term commonly used outside the US to refer to the rate at which funds are withdrawn from a retirement account.
- In the United States, we use the term "withdrawal rate" in place of "drawdown percentage."
Key Metrics and Concepts
Maximum Drawdown (MDD)
Maximum Drawdown is a critical metric that quantifies the most substantial peak-to-trough decline in a portfolio's value since it began. You can think of this as the worst-case scenario in terms of portfolio performance as it provides a clear image of the maximum loss you could have experienced. If your $100,000 portfolio fell to $60,000 before recovering, for example, you'd know that the MDD would be 40% which would help you make better decisions concerning your asset management and retirement plan.
Average Drawdown (AvDD)
Average Drawdown gives us a broader perspective of the drawdowns a portfolio experiences over a set period of time. While MDD focuses on the single largest decline, AvDD calculates the time average of all drawdowns that have occurred. What this does is provide a view of the typical magnitude and frequency of drawdowns so you can more accurately gauge your portfolio's volatility and rate of return. Say your portfolio saw three drawdowns of 10%, 15%, and 20% within the same year. Your AvDD would be the average of the three, so 15%. Knowing your AvDD means you can gain better insight into your portfolio's risk profile which again, helps you make better and more informed decisions.
Drawdown Duration
Drawdown Duration measures the time it takes for your portfolio to recover and reach a new peak after a drawdown occurs. Naturally, this duration is significant because we're talking about the amount of time your wealth is reduced - which can negatively impact your ability to meet your financial goals, especially if you’re into your retirement. If you were at $100,000 and dropped to $60,000, and then it took a year to recover back to $100,000 or even hit a new high, then your Drawdown Duration would be 1 year. It's a simple yet important calculation as it can help you assess the potential impact on your long-term investment plans as you plan for retirement.
The shorter the drawdown, the quicker the recovery and the less time you'll spend with reduced wealth. If you're nearing retirement or relying on your investments as income in retirement, this is an important metric. PensionBee makes it easy to track your retirement savings.
Impact on Retirement Accounts
Risk Management
If you wish to manage risk in your retirement accounts, understanding drawdowns is crucial. 401(k)s and IRA accounts are often the main source of income for retirees and market volatility can significantly impact your savings. A substantial drawdown that happens just before or during your retirement could jeopardize the sustainability of your withdrawals which could lead to a depletion of funds earlier than you may be expecting. Diversification and asset allocation can help mitigate the risk and ensure that your retirement portfolio remains resilient even when the market becomes turbulent. PensionBee offers different plans that align with your goals.
Sustainable Withdrawal Rates
The rule of thumb for retirement withdrawal suggests retirees withdraw 4% of their retirement portfolio in the first year, with each subsequent year adjusted for inflation, in order to have the right amount of money to last for approximately 30 years. This 4% rule sounds great in theory, but drawdowns can compromise the sustainability of this rule and cause understandable distress. If you have a portfolio worth $1,000,000 and it declines to $700,000, a 4% withdrawal goes from $40,000 to $28,000. This means that if you need to keep taking $40,000, it now represents a higher percentage of the reduced balance (5.7% to be exact). To combat this, it may be wise to consider lowering your withdrawal rate to, say, 3.8% to adjust for fluctuating market conditions.
Sequence of Returns Risk
The sequence-of-returns risk (also known as sequence risk) is the risk that the market declines when you are either late in your working life or early in your retirement and that impacts your plan. If your portfolio experiences negative returns early in retirement, it may not recover in time to support your desired retirement income. If your portfolio sees positive returns early on, you could have a nice cushion to support your portfolio during future drawdowns. Either way, being aware of the sequence of returns risk can help you plan effectively. PensionBee offers a variety of portfolios to support you through your retirement journey depending on your risk tolerance.
Strategies to Mitigate Drawdowns
Diversification
Diversification plays a crucial role in reducing drawdown risk by spreading your investments across various asset classes, sectors, and geographies. This investment strategy minimizes the impact of any single market downturn and helps to smooth out your returns and reduce volatility. PensionBee can walk you through the plan options to make sure you are happy with your chosen portfolio’s diversification.
Asset Allocation
Adjusting your asset allocation can help you manage drawdown risk by balancing your mix of stock market equities, bonds, forex, mutual funds, real estate, and other assets based on time and risk tolerance. Again, PensionBee offers a variety of plans to make sure you are happy with your asset allocations.
Dynamic Withdrawal Strategies
This could mean adjusting your withdrawal rate from your retirement portfolio based on its performance so that you can conserve your assets when the market is in decline by reducing your withdrawals.
Guaranteed Income Products
The use of guaranteed income products such as annuities can help you mitigate drawdowns by providing a predictable income stream that isn't affected by market fluctuation. These types of products make sure there's a consistent income flow which can protect you from the adverse effects of drawdowns.
Best Practices for Managing Drawdowns
Effectively managing drawdowns requires you to adopt a proactive and, frankly, adaptive approach, as one of the best practices is to conduct regular portfolio reviews and risk assessments to monitor and adjust for these potential setbacks. Reviewing enables you to assess current market conditions, evaluate the financial performance of your investments, and make the necessary adjustments to prevent potential losses. It's wise to assess your risk tolerance periodically as well, as it can change over time due to your age, financial goals, or market conditions. PensionBee makes it easy to track your portfolio’s performance, all in the palm of your hand.
Anticipate Drawdowns for Long-Term Financial Stability
Managing drawdowns is a critical part of investment planning, especially if you're nearing or currently in retirement. Learning how to anticipate these economic events is paramount, and mitigating your risk by maintaining a diversified investment approach, regularly assessing and reviewing your portfolio management approach, and being ready to adjust your strategies can help you avoid the negative impacts that befall many others. PensionBee is ready to help you be retirement confident. Please let us know if we can help you.
