Sequence of Returns Risk
Order Matters, Especially When it’s Your Portfolio Returns in Retirement
Moab Utah is one of my favorite places to visit and I often pass by a popular base-jumping location while driving from my home in Grand Junction Colorado. The cliff stands over 1,000 feet in height and while I’m sure it’s exhilarating, it terrifies me. Statistically, it is generally safe to jump, especially with a professional instructor and if you follow the steps in the right order. I have included the basic steps below.
Step 1: Fasten parachute.
Step 2: Count to 3.
Step 3: Jump!
The process sounds simple enough. However, what if you were to mix it up a little and do the steps in reverse order? Jump, count to 3, fasten parachute? The outcome would be disastrous! I think we can all agree the order or sequence of events makes a huge difference in the outcome. Investing in retirement can be the same way with the sequence in which your returns arrive materially impacting the outcome. This is referred to as the sequence of returns risk.
Why Didn’t Anyone Warn Me About Sequence‑of‑Returns Risk While I Was Working?
Many of you have heard of dollar cost averaging and employed it in your working years. If markets pulled back it wasn’t a big deal because you were putting more money into the market; buying more stocks at a discount. The end result is a high portfolio balance. However, in retirement you are pulling money out of the market and doing the opposite of dollar cost averaging. If you’re not pulling money out of your portfolio there is no sequence of returns risk. It is the new risk you face when pulling money out.
But Isn’t The Average Return of The Market 10%?
Most people ask what average return they should expect before investing in the market and it stops there. Do averages work? Yes and no. It’s been said that a person can drown in a river with an average depth of 6 inches. Extremes can hide within averages and in the case of a river, they can easily be deep enough for someone to drown. The stock market can be the same way. Your first year into retirement may start with the average or something wildly different and the order in which those returns show up is most important.
Below is a chart displaying the distribution of returns on the S&P500 over the past 100 years. Returns are grouped in 5% buckets with the frequency of occurrence shown on the vertical axis. The first thing I notice is that not all returns center around 10%. There is a concentration of returns from 15 to 30 percent. There is also a concentration of negative returns in 5 to 15 percent. On the extremes, losses, while less frequent, do exceed 40% and gains exceed 50%. While the average may be 10%, annual returns are unlikely to center around that number on a consistent basis.
Let’s Look at an Example.
Consider two investors starting with the following set of circumstances. Both have $1M to invest and plan to withdraw $50,000 in year 1, adjusted upward by annual inflation of 3% over a 20-year period. The average return over this period will be 5%. The difference between the two? The annual returns for both will be the same, however, the order in which the returns are realized will be reversed for the second investor.
Investor 1:
Over a 20-year period, investor 1 realizes total income of $1,343,519 and still has an investment balance of $812,844 remaining. This remaining balance will continue to fund their retirement.
Investor 2:
Over a 20-year period, investor 2 experiences the same average rate of return but the order in which returns are realized is reversed. After 20 years, total income is $910,939 and the remaining investment balance is $0. In fact, their balance hit zero 5 years earlier in year 15. There is no investment balance to continue funding retirement.
To summarize, investor 2 earned $432,580 less in income over 20 years and finished with $0 or $812,844 less than investor 1. All this due to one difference, the sequence in which investor 2 experienced the same returns. The average return was identical.
Data for both investor 1 and investor 2 are shown in the following tables.
Running through a simulation with returns in reverse order highlights the risk posed by sequence of returns but what action can an investor take? It’s important to separate the symptom from the underlying cause. The symptom is running out of money due to returns but the cause is withdrawing money at inopportune times. Therefore, the solution lies in managing when money is withdrawn, rather than returns. If not for the withdrawals, the outcomes would be identical between both investors.
The Retirement Risk Zone is Critical
When are you most at risk? The five years leading up to retirement and first five years into retirement, sometimes referred to as the retirement risk zone. The reason for the risk is having less time to weather a drawdown and less time to refill savings through working income. During this time, it is critical to assess your risk and how you are positioned in the market. Reducing your dependency on the market increases the odds that the retirement you envision is more of a certainly rather than a hopeful goal.
How to Prepare
The most important step is to be proactive rather than reactive. Utilize the retirement risk zone as an opportunity to assess where you stand and think through your options. There are four main options at your disposal including a dynamic withdrawal rate, the bucket method, income floors and delaying retirement. There is no one-size-fits-all approach with this, and it will come down to your unique situation and preferences. The important thing here is to be proactive and begin exploring options while you have time. Let’s explore these options.
Employ a Dynamic Withdrawal Rate
One of the simplest ways to reduce sequence of returns risk is to lower how much you live on in down markets. During bear markets, lowering the total amount withdrawn on the portfolio can help protect you. This is often referred to as the guardrail approach. When markets reward you with high returns, withdraw more. When markets experience poor returns, withdraw less. One drawback of this approach is the weight you give the market in determining how you live your life. After waiting all these years to retire, do you really want the market impacting how you live your life?
The Bucket Method
Described in my last article, this method spreads out your assets between buckets based on time. The near-term bucket with less time holds stable assets like cash and short-term bonds. The longer-term buckets hold more volatile assets. Holding assets this way, funds your lifestyle of the next few years and refills those buckets when markets are positive. This is a great way to protect your lifestyle while also participating in some of the highest growing assets like stocks.
Income Floors
This is the salary or paycheck component of the bucket strategy discussed before. People spend years having paychecks deposited into their accounts on a regular basis. Retiring without any type of paycheck can feel very different. Thankfully, there are multiple ways to establish a paycheck and most people have one established by default through social security. The other alternatives include pensions from work, annuities and rental income. Establishing a paycheck can be freeing when you know there is a regular distribution coming. These paychecks lock in a standard of living and remove uncertainty around the markets. Your life is not impacted by the whims of the market.
Delay Retirement
The last and least desirable method for those nearing retirement is to delay retirement. This is not the most appealing method for anyone excited to retire. And let’s face it, we are all getting older with each passing day. Do you really want to work an extra 5 years because a bear market showed up? This takes away from the time you could be spending traveling, with family or enjoying the community you live in without the everyday stresses of work. Furthermore, you may not have the option to delay if your health deteriorates or you lose your job.
There are many ways to prepare against sequence of returns risk with the most important being your ability to avoid drawing on your portfolio in a down year. Storing up a large investment nest egg is important but without a plan it is subject to the whims of the market and in what order it decides to reward or punish you. The most important time to prepare is within the 5 years leading up to and 5 years following retirement. If you need help planning, please reach out.
Hopefully, this article will benefit you, a friend or family member.
Thank you for taking the time to read this planning commentary. I pray it helps you or someone you care about.
Kyle Lottman, CFA, CMT, CPA
Wealth Management Advisor
Elevate Capital Advisors
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