Market fluctuations are a normal part of investing, but once you enter retirement, those ups and downs can feel much riskier, especially when you’re relying on your portfolio for income. This is where a volatility buffer comes in. It acts as a safety net, providing you with steady income during market downturns, so you don’t have to sell investments at a loss.
In this post, we’ll explain what a volatility buffer is, how it works, and why it could be the key to protecting your retirement income.
The Risk of Sequence of Returns
When you’re saving for retirement, market returns are important, but once you begin withdrawing funds, the sequence of those returns becomes even more critical. This is known as sequence of returns risk. If you experience poor market performance early in retirement, it can significantly deplete your assets, even if the long-term returns are positive.
Research shows that retirees who face negative returns in the first five years of retirement are over 30% more likely to run out of money prematurely compared to those who face losses later. For example, starting retirement during a bear market can reduce the likelihood of success for a 60/40 portfolio by up to 25%. A volatility buffer can help shield you from this risk by providing a reliable income stream during market downturns.
What is a Volatility Buffer?
A volatility buffer is essentially a financial cushion designed to protect your income during periods of market instability. Rather than having to sell investments at a loss to cover your living expenses, you tap into your buffer to maintain your income until the market recovers.
Here are the key benefits of a volatility buffer:
- Steady income during market dips
- Prevents selling investments at a loss
- Reduces the risk of running out of money
- Protects your long-term financial plan
When combined with a thoughtful withdrawal strategy, a volatility buffer can be a powerful tool for preserving your retirement.
Types of Volatility Buffers
There’s no one-size-fits-all approach to creating a volatility buffer. The idea is to use reliable, non-market-correlated assets that you can access during rough patches. Here are some of the most common types of buffers:
- Cash Reserves: High-yield savings accounts or liquid cash are the simplest options. They’re safe, easy to access, and provide stability during market downturns.
- Short-Term Bonds: These bonds are less sensitive to interest rate changes than long-term bonds and offer predictable returns, making them ideal for providing income during volatile periods.
- Fixed Indexed Annuities (FIAs): FIAs offer principal protection while still allowing for market-linked growth. They provide steady returns without the risk of losing your principal.
- Cash Value Life Insurance: Indexed Universal Life (IUL) insurance policies build cash value that can be accessed tax-free. This offers a flexible option to cover income needs during market downturns.
- Reverse Mortgages: For retirees with significant home equity, reverse mortgages provide tax-free access to funds, offering a unique way to manage income without selling your home.
Using a Volatility Buffer Effectively
Having a buffer is one thing; knowing when and how to use it is key to making it work for your retirement. To do this, set up clear activation triggers that define when you should pause portfolio withdrawals and draw from your buffer instead. Also, have recovery triggers in place to guide you when to return to regular withdrawals.
Activation Triggers
These triggers help you know when to use the buffer. Some examples include:
- Market-Based Triggers: For instance, when the market drops by 10% or more, you can switch to your buffer.
- Portfolio-Based Triggers: If your portfolio value drops by 10% from its last peak or your withdrawal rate exceeds a certain percentage, it might be time to use your buffer.
- Income Need Triggers: If your withdrawal rate exceeds 4–5% of your portfolio, your buffer can provide the necessary funds.
Recovery Triggers
Knowing when to switch back to your portfolio is just as important as when to use your buffer. Consider the following triggers:
- The market has regained its previous levels.
- Your portfolio balance has recovered sufficiently.
- Positive returns have been sustained over 3–6 months.
How Much Should You Set Aside for Your Volatility Buffer?
A good rule of thumb is to hold one to three years’ worth of retirement income in your volatility buffer. However, the exact amount depends on:
- Your monthly income needs
- Guaranteed income sources (like Social Security or pensions)
- Your risk tolerance
- Whether you’re early or late in retirement
Common Misconceptions
- “I’m diversified, so I don’t need a buffer.” Diversification helps, but it doesn’t fully protect against sequence of returns risk. A buffer is essential to manage withdrawals during market downturns.
- “Bonds are enough.” Bonds can lose value too, especially in rising interest rate environments. A well-structured volatility buffer uses more stable assets.
- “Volatility buffers are only for conservative investors.” A buffer benefits all investors, including those with riskier portfolios. It allows your higher-risk assets time to recover without forcing you to sell at a loss.
- “I’ll just cut back on spending if the market crashes.” While this may sound good in theory, many retirees have fixed expenses that can’t be adjusted easily. A buffer gives you more flexibility.
Final Thoughts: Plan Ahead
The early years of retirement are the most vulnerable, so it’s crucial to build your volatility buffer before you need it. Don’t wait for a market downturn to realize your plan isn’t as resilient as you thought.
A volatility buffer is more than just a safety net—it’s a proactive strategy to protect your income and preserve your retirement portfolio. By setting up a buffer, you can weather market storms without sacrificing your long-term financial plan, helping you maintain the lifestyle you want without the fear of running out of money.
