How to Ease Out of the Market
This is a companion blog to the one I wrote previously on using dollar cost averaging (DCA) as a way to slowly buy into the market to avoid the risk of investing a large amount of cash at a market peak. That approach works when you are in the accumulation phase of your life (the period when you are saving money). However, after you retire, you face the need to slowly liquidate your investments in order to provide the necessary cash flow to support your post-retirement goals. You’d think that DCA would work just as well in reverse. The problem is that it can result in some very uneven distributions. There is a variation of DCA that can help smooth out the income produced when distributing assets. It’s called share cost averaging (SCA).
Before getting into the methodology of SCA, it helps to put it into context. When in retirement, it’s very important to have a strategy for how you will be utilizing your investment portfolio for cash flow. I call this a distribution allocation plan. You might wonder why such a plan is even needed. After all, why can’t you just get the needed cash flow in retirement from the interest from your bonds or bond funds or the dividends from your stocks or other dividend-producing assets? It’s because few portfolios are large enough to generate a sufficient level of cash flow solely from interest and dividends, especially in today’s low interest rate environment. Most retirees have no choice but to sell their various holdings from time to time. The distribution allocation plan will specify not only how much cash flow is to come from investment income vs. asset liquidations, but also the frequency of distributions. It should also specify which accounts – tax deferred, tax free, or taxable – should be utilized, and in what order. Once you have all these plan elements defined, SCA can provide a methodology to improve the efficiency of the asset sales.
As you will recall, DCA works by averaging over time the money you spend for asset purchases. When you are in the distribution phase, however, selling 25% of an asset over time based on its dollar value can result in a very uncertain final distribution that may not meet your retirement income goals. Let’s take a look at the same example we used in the previous blog. Suppose you are holding 600 shares of an S&P 500 index fund on January 2, 2008 – worth $86,400 – that you need to liquidate for living expenses during the year. Your monthly expenses are about $7000 so you plan to sell 25% of the fund – that is, $21,600 – each quarter. If you were to follow the DCA methodology you would immediately sell 150 shares, providing you with $21,600. In April the price drops to $136, so you’d have to sell 159 shares to generate the same $21,600. In July the price drops again, this time to $126, forcing you to sell 172 shares. By the time October rolls around, there are only 119 shares left, and the price has plummeted to $112. You’d get only $13,328 to spend during the last three months of the year, barely more than half of what you’d been expecting. You probably wouldn’t be forced to start eating dog food, but you can probably forget about buying those Nutcracker ballet tickets.
SCA solves the problem by having you withdraw 25% of the shares rather than 25% of a target dollar amount. Following the same example, you’d get $21,600 in Q1, $20,400 in Q2, $18,900 in Q3, and $16,800 in Q4. Although the distributions start declining earlier, they change much less dramatically from one quarter to the next, even during such a volatile time as 2008. The SCA approach helps even out the distributions and additionally aligns them better with market performance. And you avoid much of the uncertainty associated with the last distribution.
How would SCA work in a growing market? Let’s go back to 2013. Following the DCA methodology your withdrawals would have been $21,900, $21,900, $21,900, and $29,400. Utilizing SCA they would have been $21,900, $23,500, $24,200, and $25,350. If you like the idea of getting a bonus, DCA would have been the better approach. If you prefer steadier income aligned with market performance, you’d have gone with SCA. We cannot know future market performance, so the choice is largely a matter of one’s comfort with income variation during retirement.
There’s no right or wrong approach to liquidating your investments in retirement. You could simply choose to sell an entire holding and keep the distribution in cash for a year. But in that case you might end up selling when the asset price is exceptionally depressed. That’s the same situation which DCA was designed to avoid when buying assets, and which SCA addresses in reverse. The good news is that you have a choice of distribution methodologies. Whichever one you select, it should be based on your retirement plan as well as your personal risk tolerance. During retirement you are much more dependent on your investments for income, so it’s important to have a plan that supports your spending goals.