“You don’t have to swing hard to hit a home run. If you got the timing, it’ll go.” – Yogi Berra
A Not-So-Well-Known Risk to Retirees – Sequence of Returns Risk – and What You Can Do to Mitigate It
Retirement is one of the most significant things in life. Going from a lifetime of earning and saving is akin to going uphill, which is difficult, but we get used to it after a few decades. Preparing for the next chapter of spending is akin to going downhill. While this chapter can be more enjoyable than the previous one, it can also be more stressful, especially if we are going downhill too fast.
The ideal retirement is a time to relax, enjoy the fruits of one’s labor, work on passion projects, spend time with loved ones, and, most importantly, do so with minimal stress and maximum peace of mind.
Many retirees face a challenge that can interrupt that ideal retirement, though.
Imagine entering retirement with peace of mind as you plan out this next chapter of life. Yet, once you retire, instead of looking forward to family visits and travel, you look closely at your retirement account statement, which shows that you are losing money. Now, this usually isn’t a big deal in any given month, quarter, or even year. Investments fluctuate, and it’s pretty normal to have a down year occasionally. But what if years 2 and 3 are also sub-par? What if the entire first decade of investment returns during your retirement are lackluster? This is where a retiree goes from having peace of mind and living the life they have been dreaming about, to now losing sleep wondering if they’ll have to return back to work.
Many retirees accept that drawdowns will occur, but the severity and timing are more critical than most people realize. Even mild drawdowns at inopportune times can be pretty damaging to a retiree’s quality of life in the long run.
During our golden years, most of us need to withdraw from our investment accounts to maintain our quality of life. When we start to draw them down, AND the investments don’t perform well at the same time, we are exposed to ‘sequence of returns risk’. This risk isn’t about the return amount, but the order in which investment returns occur during retirement. Believe it or not, the timing of a downturn can drastically impact the sustainability of a retiree’s portfolio.
We can’t time the market, and neither can anyone else. But we can build resilient portfolios that create a buffer against unfortunate timing.
Let’s look at a side-by-side example showing how drastic this risk can be. The left part of this image below shows the retirement account details of a hypothetical retiree ‘Jane’. Jane is 66 years old, with $500k in her retirement account, with a current need of $20k per year. She earns about a 4% return per year on average.
The right part of this image shows the same retirement account details for another hypothetical retiree ‘Jim’ who has all the same relevant factors. Age, asset level, average return, and withdrawal need are all identical.
The only difference between these 2, is that their returns are reversed throughout the 15-year period.
Jane has a few negative years to start retirement, with most of the subsequent years being positive. And Jim has mostly positive returns early in retirement, with most of the consistent negative returns happening later in retirement. The return #s are precisely the same, just in reverse order from each other.
The real story is told in the ‘ending value’ column of the charts above.
In the example, Jane had 3 years of negative returns to start retirement which dug her into a hole that wound up depleting her assets to under 100k within 15 years. She is on pace to deplete her assets all the way down to 0 within a few years after turning age 81. Her portfolio was never higher than 400k again after year 1 of retirement.
Jim on the other hand finishes the 15-year period still with 344k, and only 3 years of the 15 were spent under 500k. He can still fund his retirement for many years to come, even if his portfolio had further downturns, he would still be ok.
Nobody wishes for downturns. And many retirees won’t have as volatile returns as the examples above, but even with less volatility, the core message of this article is still true. Many retirees will face some periods of questionable returns. If that happens to occur early in retirement, there is an added layer of concern. The key period to be very mindful of in the real world is the first decade of retirement. It is very important to position the portfolio not only to grow, but also to be able to go the distance. This is a legitimate threat to new retirees that they need to be aware of, particularly for retirees who are withdrawing from their retirement account each year.
While this risk is genuine, there are some ways to see it coming and prepare ahead potentially. Mitigating its potential impact is done through careful asset selection, dynamic investment management, measured asset allocation adjustments, proper diversification, monitoring of market valuations and conditions, and carefully selecting and adapting withdrawal rates as needed.
Careful asset selection, and dynamic management of the investments. When investing the wise way, one of the key variables for long-term success is asset selection. This is much like a sports team selecting the right players. You don’t need the flashiest assets. Quality assets that do their job well. They may not hit you home runs every time they step up to bat (No athlete and no asset have a perfect batting record), but they consistently get you singles and doubles. If your portfolio is set up in a way where it is too aggressive, (Looking for too many home runs) your susceptibility to risk (or striking out) is higher. So, the correct solution is to minimize risk and properly adjust the portfolio in a direction that is more suitable for your situation.
Measured asset allocation adjustments. Asset allocation is how much you own of each broad asset class. Each has its own pros and cons, and each performs differently in different economic environments. If you had all your money in cash throughout the 1970s, you could have lost anywhere from 20-50% of your purchasing power (due to inflation), depending on what you were earning on that cash. If you had all of your money in stocks in the 1999-2001 period, your portfolio had substantial downside when the tech boom turned into the tech bubble. If all your money was leveraged against real estate in 2007-2008, the same problem. Each of those could be considered a quality assets, but they all have times that they do well and other times that they do poorly. And as humans, we often compound that downside by making emotional errors during times like these, such as locking in losses rather than waiting for recoveries.
A better approach is to adjust the amount we own of each asset according to our own personal risk tolerance along with the current economy to minimize the downside. Putting all of your assets into one category hardly ever makes sense. Some people go from 100% real estate to 100% cash to 100% stocks. They whipsaw themselves and their portfolios with every emotional change. The best asset allocation adjustments are done gradually. Those gradual changes make the returns smoother and more predictable, similar to how an experienced driver drives a car. If you’ve ever driven with an inexperienced driver, many movements they make with the car are very rough and sudden. Sharp turns, slamming on the brakes and the gas, changing lanes too fast without looking. Not only is this bad for the car, but it’s also incredibly unsafe, and even if you make it to the destination, it can give the passengers a heart attack from the stress. You can tell a portfolio is well built when the ride is smooth sailing, much like the experience you have when being a passenger with a careful and competent driver. The passengers barely have to pay any attention because they trust that the wise driver isn’t putting them in any danger, and the ride is smooth and comfy all the way to the final destination.
Proper diversification. There is such a thing as improper diversification, and many people fall victim to it without realizing it. Just because you own a fund that holds 500 companies does not make you properly diversified. During certain times, correlations of those 500 companies can be very close to each other, meaning that the entire fund can fall or have sub-par performance (Or a majority of it falls while the other portion stays at roughly the same value, which can still equate to large downside). Proper diversification takes into consideration not just the # of stocks but also the location of those stocks in the world, the size of the companies, the sectors that each company are in, AND other assets outside of the stock market. (Did you know that the SP500 has had 2 separate 25-year periods where it was down the entire time in inflation-adjusted terms?)
Both charts referenced are from – https://www.macrotrends.net/2324/sp-500-historical-chart-data
Regular monitoring of market valuations and conditions. When you go to the grocery store, sometimes milk will be a regular price compared to every other time you bought it: other times, it’s on sale. And sometimes, it may be higher than usual. The same dynamics exist in investments with even more volatility. Financial Professionals monitor these movements and keep their eyes out for opportunities to buy and sell assets that have become mispriced in either direction. There are various ways to measure the valuations of investments to determine a probabilistic outcome of their long-term outlook. These tools help us figure out if an asset’s expectations should be higher than average, lower, or about average over a given timeframe. We utilize tools 1, 2, and 3 mentioned above to attempt to prudently position our portfolios.
Carefully selecting and adapting withdrawal rates as needed. If you withdraw too much, this further exacerbates the risk you experience. But how do you know what amount is too much? Well, there’s not an exact answer that holds true for everyone because all of our circumstances are different, but a good place to start is ‘the 4% rule’. This is a pretty good estimate of how much you can afford to withdraw from your retirement accounts each year during retirement. This amount is reasonable because a well-diversified investment portfolio should often outperform that 4%, which means your portfolio could grow throughout your retirement despite taking withdrawals. But remember, it’s just an estimate or a place to start, not necessarily a number that you should commit to year in and year out with high confidence. A 100-year-old can probably afford to take 5-7 % out of their portfolio yearly because they likely won’t have to fund 20-30 more years of retirement. Whereas a 60-year-old might be more comfortable with 1-3%. (Remember that if your retirement funds are in a taxable account, your withdrawal is not the amount that you will net yourself but the total amount coming out of the account each year.)
The 4% rule can also be too conservative leaving too much money in their accounts at the end of retirement. This is why we often adapt withdrawal rates to the economic environment and the needs of the client.
Yes, quality investments that go down often recover back to their all-time highs at some point, and most people who hang on without selling can weather the storm. Remember even for investments that recover, a retiree that is drawing down from those investments may not experience that full recovery because they are selling assets each year to fund living expenses.
While the sequence of returns risks that you personally experience can threaten your financial well-being, this risk can be mitigated by taking the proper steps to make your portfolio extra resilient.
If you haven’t done a careful deep dive into your own finances from the perspective of risk, then it may be time to ask yourself a few questions.
‘How much risk am I currently taking?’
‘How much risk can I afford to take?’
‘How well am I utilizing all five solutions above?’
It certainly would be wise to answer these questions sooner rather than later. Many retirees don’t realize their portfolio’s downside and don’t know how much downside they can safely sustain.
We were on WPDE Channel 15 recently sharing tips on how students can tackle college debt. Click here to view.
We were mentioned in Financial Planning talking about Taylor Swift. 😊 See, we like to have fun too! LOL.
On the lighter side, I turned 50 on Thursday last week. See Elliott’s card below. Iren and I went to see the movie Oppenheimer and out to dinner. Home by 8p that was topped off by Key Lime Pie. It was a perfect evening.
I hope all is well with you and your family,
Finger Financial Five – 5 points in 5 minutes or less – is to provide you with a weekly shot of useful financial information. My intention is to share principles, so that you will have more clarity and peace, that help you make better financial decisions.
Investment advice offered through Stratos Wealth Advisors, LLC, a registered investment advisor. Stratos Wealth Advisors, LLC and Riverbend Wealth Management are separate entities.
This content is developed from sources believed to be providing accurate information and provided by Riverbend Wealth Management. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Stratos Wealth Partners and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.
Riverbend Wealth Management does not compensate existing or former clients for testimonials or endorsements.