When it’s time to retire, investors realize that saving and growing was just the start of the retirement journey. The next phase is to invest those assets to provide income to live on for an entire retirement.
A common retirement goal is do not out of money before you run out of life. One of the biggest risks to a retirement plan is a period of negative returns early in retirement. That’s when you have the most capital invested, and that money also has to last the longest amount of time. Early retirement is also often when people are drawing the highest income out of their retirement plans as they adapt to an active new lifestyle. These pressures have the potential to push a retirement plan off-course.
The risk that a portfolio will experience negative returns in early retirement is called sequence of returns risk. There are ways to mitigate it, but first, it’s important to understand how it affects a portfolio.
What Is Sequence of Returns Risk?
One of the biggest risks that come with taking distributions from a retirement portfolio is bad timing. For example, investors who would have retired in 2007 would have experienced a market of significant negative returns right after they retired. If the retiree is leaning on the investments for income, they may be forced to sell investments to meet their distribution needs at low points in the market. Since that portion is no longer invested, the time it takes to recover any losses is extended. It can lead to a situation where the portfolio can no longer sustain those distributions, forcing an adjustment of lifestyle to avoid running out of money. The risk is particularly high for younger retirees. A 65-year-old retiree potentially has a lot more years of retirement to fund than a 90-year-old retiree.
As an overly simplistic example, let’s look at a hypothetical portfolio of $1,000,000 starting with an annual withdrawal rate of 40,000 under two different return environments.
The portfolios experienced the same annual returns – just in the reverse order. Over the four-years, the portfolio that experienced the negative returns first was down almost $75,000 compared to the portfolio with the luckier return stream. That’s almost twice the annual withdrawal requirement – and over time, without a very strong positive stream of returns – that could be a significant problem.
Reduce Risk Through Asset Allocation
One way to mitigate sequence risk is through proper asset allocation. Asset allocation divides an investment portfolio into different asset classes such as stocks, bonds, real estate, or cash. It can help protect against sequence risk because you’re placing portions of assets outside of the stock market, intending to smooth out the ups and downs of your returns.
When the stock market is heading south, diversification aims to have enough money placed in other asset classes or categories to ride out the volatility. By investing in assets that play different roles with low correlation with each other, you can begin to create balance in your portfolio that helps to withstand changing market conditions.
Use a Time-Bucket Strategy
Another way to help mitigate sequence of returns risk is by utilizing a time-bucket approach to retirement investing. Time-bucketing divides your assets by the timeframe in which you are likely to need them. Funds needed in the immediate future, say within the next year or two, are primarily held in cash or other short-term investments. Money needed within the intermediate time frame, two to five years, would potentially go to laddered fixed bonds or CD’s. Funds needed in five years or later can be put towards growthier investments such as stocks.
This helps the portfolio ride out a period of negative returns by avoiding the need to sell off investments in a down market. The assets needed to meet upcoming distributions should be set, in low-risk investments that typically would not experience big declines. It gives the longer-term bucket time to recover before they will be needed.
Before implementing a time-bucket strategy, it’s important to understand your short-term income needs so you can appropriately allocate funds in the correct buckets. No one likes doing it, but retirees need to put in some time reasonably estimating a budget for this strategy to work. While you may miss out on some potential returns by holding years of expenses in cash, the trade-off for increased stability and peace of mind may be worth it.
The Bottom Line
We say it over and over, but it bears repeating here. There is no one-size-fits all solution in retirement planning. Risk presents itself in some way, shape, or form in every retirement plan, whether that is the sequence of return risk, investment risk, longevity risk, etc. Understanding both your comfort level with risk and your income needs are some of the first steps to formulating a plan. With the many ways to approach risk management, it is sometimes confusing to sort through the different strategies. If you need some guidance, Michelle and I would be happy to talk.
This material is provided as a courtesy and for educational purposes only. Please consult your investment professional, legal, or tax advisor for specific information pertaining to your situation. Investing involves risk including loss of principal. Past performance is not indicative of future results.