INVESTING • READ TIME: 8 MIN
"Planning is bringing the future into the present so that you can do something about it now."
Alan Lakein
Time is on Your Side...Until It Isn't
Market volatility, attention-grabbing headlines, and the ease of access to real-time financial data can be anxiety-inducing stimuli to even the savviest of investors. However, there is one often-overlooked facet of wealth building and creation: time. A sensibly constructed, well-diversified portfolio can often weather any short-term storm over a long enough time horizon.
What happens, though, when an investor is simultaneously “in the throws” of a turbulent market – a secular bear market, for example – and is in the early stages of retirement (or just on the cusp of retirement)? The risk of outliving your money (longevity risk), given this scenario, can become quite real.
The primary driver for longevity risk in the previous example is the concept known as “sequence of returns risk.” This is the interaction of adverse market conditions and scheduled distributions which (together) make losses difficult to recoup and decrease the likelihood of a portfolio sustaining an investor for the duration of their retirement.
What is Sequence of Returns Risk?
Sequence of returns risk is also known as sequence risk. Essentially, it is the risk that comes from the order in which investment returns occur.
As illustrated later in this article, sequence risk should be “top of mind” for investors approaching retirement and/or in the early stages of retirement. Market declines early in retirement coupled with ongoing withdrawals dramatically reduce portfolio longevity.
If a portfolio is not positioned properly, an investor may be forced to do the opposite of the adage, “buy low and sell high.” Liquidity needs for required minimum distributions (systematic withdrawals) may result in the sale of securities at a less than ideal time. Over time, this ill-timed selling (to fund distributions) can completely deplete a retirement account.
Illustrating Sequence of Returns Risk
The tables and downloadable PDF below more fully illustrate the impact of sequence of returns risk on a retirement portfolio. Both investors – Investor A and Investor B – start their retirement with $1,000,000. They each withdraw $40,000 (inflated by 2% each year) and have the same geometric mean return: 4.275%. The only difference between these two portfolios is the sequence of their returns in retirement.
Investor A begins retirement with positive returns nine out of the first ten years. Investor B has negative returns seven out of the first ten years of retirement. Furthermore, the returns of each portfolio are the same, but in reverse order – Year 1 for Investor A is Year 20 for Investor B, etc.
Click here to view/download the full worksheet: Sequence of Returns Risk - RPWA
As we can see from the tables above, Investor A has almost $850,000 remaining after withdrawals and market fluctuations over twenty years. Investor B, however, is unable to fully fund a withdrawal in “Year 19” – as in, this portfolio can only sustain Investor B’s retirement (fully) for 18 years.
In “The Lifetime Sequence of Returns: A Retirement Planning Conundrum” (2013), Dr. Wade Pfau posits that negative returns incurred during the early years of retirement are the most detrimental. In fact, “77% of the final retirement outcome can be explained by the average return of the first 10 years of retirement.”1
How to Mitigate Portfolio Drawdowns in Retirement
Our example, along with the findings of Dr. Pfau, illustrate that sequence risk, without proper planning or flexibility, can be a matter of luck. If an investor retires during a bull market, their account may grow enough to withstand a significant downturn later in retirement. If an investor happens to retire in a bear market, the portfolio may never fully recover. Early market declines, paired with withdrawals (and rising inflation), can have a massive impact on a retiree's nest egg.
External factors – market returns - are not under an investor's control, but there are opportunities to limit downside risks in retirement. Hence, appropriately timing retirement, being mindful of asset allocation, and spending flexibility are of the utmost importance. Below are a few potential strategies for mitigating the impact of drawdowns early in retirement on a portfolio’s longevity.
"Deferring" Retirement to Increase Savings
One commonly discounted (though sometimes unpleasant) solution is to delay retirement. By postponing retirement, an investor has the opportunity to continue to contribute to retirement accounts and delay withdrawals – thus, bolstering a nest egg.
If that is an unpalatable option, "retired" investors may explore the possibility of generating supplemental income through a part-time job or passive income stream. The primary aims for these strategies are to increase savings, delay retirement withdrawals, and to identify a more opportune time (based on market conditions) to retire.
Mindful Spending and Budgeting Flexibility
Another method to protect savings is to maintain a flexible budget in retirement. Responsible budgeting and spending depend upon proper planning and a mindful, market-based approach to withdrawals. If returns are negative or inflation is higher than anticipated, it is prudent to decrease overall spending to preserve the retirement portfolio. Conversely, if returns are greater than expected or inflation is lower than anticipated, spending may be increased.
Portfolio Diversification Within/Across Asset Classes
A diversified investment portfolio should be the focal point of any retirement plan. As outlined previously, the makeup of any given portfolio should reflect personal risk tolerance, investment objectives, cash flow needs, and tax situation(s).
In general, the ideal portfolio for any given investor should align goals and needs with sensible diversification within and across different asset classes. For investors nearing (or in) retirement, an increased allocation to stable, income-oriented assets (such as bonds) is recommended.
Regardless of the allocations, over time, assets will increase and/or decrease in value. A diversified portfolio takes advantage of different correlations between assets in an attempt to limit portfolio volatility. Ideally, a balanced portfolio will create a stabilize return pattern. Over an extended period of time, this is likely to offer a more desirable outcome (meeting retirement income needs, for example) than a less-diversified approach.
Diversification and asset allocation are methods used to help manage investment risk; they do not guarantee a profit or protect against investment loss.
Insure Your Income with an Annuity
Finally, income streams generated by an annuity may help protect against sequence of returns risk (as well as longevity risk – outliving your money). An annuity, used for the purpose of funding retirement, is an insurance contract that allows an investor to save money now (in the case of a deferred annuity) to generate income later in retirement.
Lifetime income streams may be funded via variable annuities (VAs) or fixed index annuities (FIAs) offering guaranteed lifetime withdrawal benefits (GLWB). Distributions from annuities can be paid out in monthly, quarterly, or yearly cycles.
Guarantees are based upon the claims-paying ability of the underlying issuer.
To learn more about annuities, check out the RP Wealth Advisors article: What is an Annuity?
Summing It All Up
A return sequence is the phrase that describes the year-to-year returns garnered by a portfolio for a given period. As was demonstrated in the example, equal geometric returns between two different portfolios does not always guarantee the same outcome. In fact, the order of returns is quite significant - this is especially true for a retiree with systematic distributions (or an investor approaching retirement).
Adverse returns in the early years of retirement subject an investor to both longevity risk and sequence of returns risk. Ultimately, poor market conditions, higher than anticipated inflation, inflexible budgeting/spending, etc. can run a retirement portfolio to zero - an outcome most retirees will not accept.
Fortunately, there are some preventative measures investors can take. These measures include delaying retirement or generating some supplementary income while retired, paying close attention to spending and budgeting during retirement, maintaining a flexible approach to withdrawals, diversifying your investment portfolio, and using different investment vehicles to create income streams.
Most importantly, the suggested methods are most beneficial if considered and implemented prior to retirement. In short, planning, communication, and goal-setting are essential - and we are here to help. If you have questions about your own retirement, funding methods, or strategies for combatting sequence of returns risk, our team one call or click away: call or schedule an appointment with the RP Wealth Advisors team today to learn more about how we can help facilitate your successful retirement.
1. Pfau, Wade D., The Lifetime Sequence of Returns: A Retirement Planning Conundrum (September 1, 2013). Available at SSRN: https://ssrn.com/abstract=2544637 or http://dx.doi.org/10.2139/ssrn.2544637
The content is developed from sources believed to be providing accurate information. All investing involves risk, including the possible loss of principal, and there is no guarantee that any investment strategy referenced here will be successful. The information in this material is not intended as tax or legal advice. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. This material was developed and produced by RP Wealth Advisors to provide information on a topic that may be of interest. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.