With the stock market at all-time highs and normal volatility, it's easy for retirees, near-retirees and even advisors to become complacent about sequence risk, one of the biggest risks to an exit nest egg. in retirement and the saver's peace of mind. No one knows exactly when the next big market correction will occur, but when it does, as we saw in 2000-2003 and 2008-2010, sequence risk (aka sequence return risk) can wreak havoc on retirement projections and planning.
Sequence risk refers to the devastating impact that poor investment returns can have on a retiree's savings if they occur in the early years of retirement—or shortly before one plans to retire. It can cause a retiree's income to drop significantly or set off a downward spiral that is difficult to escape.
TMaking distributions when the market has dropped significantly effectively “costs” the retirement plan more than it can sustain. This causes a retiree to make major financial adjustments to their future distributions and lifestyle – something no one wants to deal with at any age.
The table below shows the impact of sequence risk on three investors who began receiving distributions in 1973, 1974, and 1975, respectively. Assumptions were based on each investor withdrawing $25,000 a year in income, plus inflation.
Depending on when each investor started receiving distributions, the results are quite different. Investor 1 (begins 1973), Investor 2 (begins 1974) and Investor 3 (begins 1975).
Even if each investor started with $500,000 in a balanced portfolio (split evenly between stocks and bonds) and rebalanced every month, they would have achieved very different long-term results. Also assume that the portfolios were each the investor's sole source of income for 35 years in retirement and that each withdrew $25,000 per year (5%), adjusted for inflation.
Before considering withdrawals,
- The 1973 retiree had a long-term return of 7.12%.
- The 1974 retiree had a long-term relapse of 8.81%.
- The 1975 retiree had a long-term return of 14.12%.
After factoring out withdrawals, they also experienced different lifestyle outcomes. The 1973 retiree, who quit his job in a major market downturn, would have run out of money after just 24 years of retirement. However, by postponing retirement just one year, the 1974 retiree — who quit at the end of the 1973-74 bear market — would have seen their nest egg last 31 years. In contrast, the 1975 retiree, who quit at the start of a bull market, saw a significant increase in her retirement account and was able to leave an inheritance of about $135,000 after 40 years of retirement.
Again, here are some of the biggest risks of sequence risk:
- Impact on portfolio longevity. If a retiree experiences negative returns early in retirement and withdraws funds from their portfolio during those years, they may deplete their nest egg much faster than expected. This can cause their portfolio to fail prematurely. Once a downward spiral begins, it is difficult, if not impossible, to escape it.
- Sequence matters. The order in which investment returns occur has a significant impact on the overall growth and longevity of a portfolio. Experiencing negative returns early in retirement can be more detrimental to a retiree's long-term distributions than experiencing the same negative returns later in retirement, ie, after the portfolio has had more time to grow .
- Withdrawal Rate Considerations: Sequence risk is closely related to a retiree's withdrawal rate. Higher withdrawal rates increase the impact of sequence risk. This is because a larger percentage of the portfolio will be withdrawn when potential negative returns can drain the account faster.
Four ways to minimize your customer churn risk
1. Maintain spending flexibility. Here we maintain a balanced investment portfolio allowing for flexible spending. We mitigate sequence risk by reducing expenses following a portfolio downturn. This allows more money to remain in the portfolio so that it can participate in any subsequent market recovery. However, the retiree has less disposable income during this period.
Withdrawing a constant percentage of remaining assets minimizes the risk of sequence of returns. It is important not to put too much pressure on the portfolio during the early years of retirement. While a constant withdrawal rate can reduce the pressure, if the portfolio falls 20% to 30% in a year, then the income withdrawal only increases the amount the portfolio needs to recover. This is a risky strategy and may cause a depletion of assets in the future.
2. Reduce volatility (when it matters most). Basically, investors should not expect constant expenses from a market-based portfolio as the likelihood of volatility is very high. Those who want upside — and who are willing to accept volatility — should be flexible with their spending and consider holding off on withdrawals until the storm passes. Retirees can reduce volatility by building a portfolio based on distribution rather than growth. This means they set aside expected distributions in a bucket and then invest the remaining portfolio without withdrawing funds.
Expenses could remain constant if the portfolio were “risk-free.” To obtain ongoing expenses, clients may seek to hold fixed income assets to maturity or use risk pooling assets such as income annuities or other fixed assets. Other approaches to reducing downside risk (volatility in the undesired direction) may include the use of an increasing equity slip path in retirement. The path starts with an equity allocation that's even lower than typically recommended at the start of retirement, but then slowly increases the equity allocation over time. Doing so can reduce the probability and magnitude of retirement failures. This approach reduces vulnerability to the early retirement stock market downturns that cause the most damage to retirees.
Asset allocation can also be achieved with a funded ratio approach. Here, more aggressive asset allocations are used only when there are sufficient assets beyond what is needed to meet retirement spending goals. Finally, financial derivatives or income guarantee drivers can be used to set a limit on how low a portfolio can fall while sacrificing some potential upside.
3. Buffer assets – avoid selling at a loss. Here clients place other available assets outside the financial portfolio from which they can draw after a market downturn. Returns from these assets should not be tied to the financial portfolio as the purpose of these buffer assets is to support spending when the portfolio is down. A time-honored strategy in this category is to keep a separate cash reserve — say two or three years of retirement spending — separate from the rest of the investment portfolio.
While hedging assets is a safe approach, there is the opportunity cost of not having these assets in other higher yielding areas. Since money can be a barrier to a portfolio, “alternatives” have been used more and more in recent years.
4. Bucket strategy: This involves segmenting a retirement portfolio into different “buckets” or groups of assets, with each bucket serving a different purpose (eg, short-term cash needs, medium-term investments, long-term growth).
The idea behind this strategy is to access cash in the short term so that a retiree does not have to worry about stock market fluctuations. In theory, they shouldn't need to sell their investments during a down market to fund their annual withdrawals.
Here are the suggested allocations for each of the three buckets:
- The instant bucket contains short-duration CDs, T-bills, high yield savings accounts and other similar assets. Ideally, customers keep enough cash in the instant bucket to fund living expenses for up to two years.
- The intermediate (middle) bucket covers expenses from year 3 to year 10 of retirement. The money in the intermediate bucket money must continue to grow to keep pace inflation. However, investors will want to avoid investing in high-risk assets. Possible financial instruments include bonds and CDs with longer maturities, preferred stocks, convertible bonds, growth and income funds, utility stocks, REITs and more.
- The Long-Term bucket contains investments that match historical stock market returns. These assets grow the client's nest egg better than inflation, while also allowing them to replenish their immediate and intermediate buckets. Here, we deploy a diversified portfolio of stocks and related assets. It should be spread across domestic and international investments, ranging from small-cap to large-cap stocks.
Investors trust you to do what is always in their best interest. They are not so much focused on returns as they are on protecting their capital. Your value comes from reducing financial (and psychological) risk and providing a long-term investment framework that can weather any financial storm.
Dr. Guy Baker IS founder of Wealth Teams Alliance (Irvine, CA).