When it’s time to retire, many investors find that saving was just the start of the retirement journey. The next phase is to invest those assets so that they provide income to live on for an entire retirement.
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 it has to last the longest amount of time. Early retirement is also often the period when people are drawing the highest income out of their retirement plans, as they adapt to an active new lifestyle. These pressures can significantly reduce the amount of projected retirement capital.
The effect on a portfolio of a period of 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.
One of the biggest risks that comes with taking distributions from a retirement portfolio is bad timing. Even with a conservative withdrawal strategy (4% per year is standard), if combined with a market downturn early in retirement, those first withdrawals could potentially negatively impact your portfolio for the duration of retirement.
Liquidating assets when the portfolio is at a lower asset value due to negative market performance crystalizes the loss and the smaller portfolio then has a more difficult time recovering.
Let’s look at a hypothetical portfolio experiencing two different return environments in the first four years. The beginning value of the portfolio is $1 million. After the first year, the annual return is subtracted from the previous year’s Final Value, which is the impact of portfolio returns (+ or -) less withdrawals.
Source: Seven Group
The portfolio experienced the same returns – just in the reverse order. Over the four-year period, 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 withdrawals – and over time, without a very strong positive stream of returns – it could be a significant problem.
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 assets outside of the stock market and capturing a broader range of returns.
A diverse portfolio can provide different ways to generate income and returns. The goal of diversification is to have enough money placed in other asset classes or categories to smooth out volatility, as assets perform differently during the same market environment. By being invested in assets that play different roles and are not correlated with each other, you can begin to create balance in your portfolio that helps to withstand changing market conditions.
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 that will be needed in the immediate future, say three years or so, are primarily held in cash or other short-term investments.
This helps the portfolio to ride out a period of negative returns by avoiding the need to sell off investments in a down market. Investment horizons are generally divided into intermediate-term assets which are held in capital preservation strategies that also throw off income and long-term assets that are earmarked for growth. These longer-term assets have the longest amount of time to recover from downturns before they will be needed.
Before implementing a time-bucket strategy, it’s important to o understand short-term income needs so you can appropriately allocate funds in the correct buckets. While you may miss out on some potential returns by holding several years of expenses in cash, the trade-off for increased stability and peace of mind may be worth it.
Diversifying into bonds creates a less-correlated asset that can potentially perform well when the stock market is struggling. It can also provide a source of income from the yield on the bonds. However, bond markets are at the mercy of the bulls and the bears too, and they are susceptible to interest rate risk.
The goal of a bond ladder is to reduce the interest rate risk by purchasing multiple bonds with different maturities. This minimizes the possibility of the entire portfolio maturing and needing to be replaced in a period in which yields may not meet income needs. In addition, it allows for some flexibility in generating cash flow as each bond matures at a different time. Taken together they can provide predictable inflows of cash.
Risk is part of every retirement plan. Understanding your risk tolerance and your income needs is crucial to effectively managing sequence risk. Working with a trusted financial advisor can help remove complexity and uncertainty around your retirement strategies.
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The information contained herein is intended to be used for educational purposes only and is not exhaustive. Diversification and/or any strategy that may be discussed does not guarantee against investment losses but are intended to help manage risk and return. If applicable, historical discussions and/or opinions are not predictive of future events. The content is presented in good faith and has been drawn from sources believed to be reliable. The content is not intended to be legal, tax or financial advice. Please consult a legal, tax or financial professional for information specific to your individual situation.
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