Imagine this scenario: You have been diligently saving and investing for years in preparation for retirement. The time has come for you to “pull the trigger.” You retire. You begin enjoying the extra time with your children and grandchildren, planning some travel and participating in spare time recreational activities you weren’t able to engage in while you were working.
Imagine further that shortly after “pulling the trigger,” stock values plunge over 50% during the next 18-24 months. US gross domestic product (GDP) falls. Unemployment increases to 10%. Interest paid by FDIC insured banks fall to levels for many years so low as to not be reasonably helpful sources of income.
You watch your retirement portfolio decline before your very eyes. Were you just unlucky in your retirement timing? Should you have anticipated an economic decline? Should you liquidate your investments and keep your assets in FDIC insured cash?
Something akin to the hypothetical described above actually happened in connection with the Great Recession of 2007- 20091. There were people who retired just before the crash. Were they unlucky? There were also people who retired after 2009 as the markets improved. Were they simply lucky?
We do not know and cannot predict the timing of the sequence of market upturns and downturns. Clearly, retiring just prior to an extended downturn is not as beneficial as retiring just as an extended upturn is beginning. In addition to the adverse impact of a downturn occurring soon after retirement, a downturn occurring during the few years prior to retirement can also negatively impact the size of the portfolio available to fund retirement. In fact, the five years prior to retirement and the five years after retirement have been referred to as the “fragile decade.” 6
Sequence of return risk may be defined as “the risk of negative market returns occurring late in your working years and/or early in retirement.”2 I believe it is one of the most significant risks retirees and prospective retirees face. The risk may also be compounded by its somewhat insidious nature which helps it to “fly under the radar” especially in cases where financial advice is not sought. Like many other retirement risks, sequence of return risk is better handled when planned for in advance than by reacting after bad things happen.
The truth is some people may be luckier than others. However, relegating retirement success to luck may be an unnecessarily harsh and damaging attitude and implies we have no control over our financial future. That simply is not so.
ADDRESSING SEQUENCE OF RETURN RISK
A retirement portfolio may be stress-tested in the years prior to retirement to gain some insight as to its vulnerability to volatility. Monte Carlo simulation software is widely available among advisors to model potential outcomes when certain variables, such as market returns, are manipulated3.
Addressing sequence of return risk is a planning issue and a process, not an event. It may encompass one or more strategies. Certainly, the planning foundation is a good understanding of your retirement objectives and their relative priorities. Once the objectives and priorities are defined, a well-allocated, diversified and tax-efficient retirement portfolio is designed to achieve those objectives. The design of the portfolio may need to be modified over time as objectives and priorities may change.
From the discussion above, we understand that withdrawing funds from a portfolio during a market downturn to support retirement can increase the risk of portfolio failure. Therefore, one way to address sequence of return risk may be to create a glidepath of portfolio investment risk reduction in the years immediately preceding retirement to reduce the potential impact of a market downturn on the portfolio during those years. Maintaining a reduced risk portfolio during the early years after retirement can also help to limit the impact of a downturn4, 6.
Another way to address sequence of return risk can include using a bucket investment strategy. The goal is to avoid the need to liquidate volatile securities to make withdrawals during a market downturn by dividing the retirement portfolio into three buckets: (1) a liquidity bucket to address needs for a 3 – 5 year period, especially useful during market downturns; (2) a short-term asset allocated investment bucket to address potential needs for up to 10 years; and (3) an asset allocated long-term or legacy bucket2. However, this is not a “set it and forget it” strategy as it must be managed as the shorter-term buckets are replenished periodically from the longer-term buckets.
Sometimes more than investment manipulation is needed to maintain a successful retirement. Periodic portfolio stress-testing can provide an early warning that more may be needed such as increasing income through a part-time job or reducing expenses. Perhaps even a phased retirement plan, where you transition into retirement over time, may be an effective strategy where it can be arranged with the employer, adequate health care can be maintained, and it doesn’t adversely impact other retirement benefits5.
IN SUMMARY
Sequence of return risk may not be top of mind for you or for most retirees and pre-retirees, but I believe it should be. Planning to address it is a process that needs to be coordinated with the remainder of your retirement and financial planning. Moreover, whatever strategies are used to address sequence of return risk need to be monitored and managed or else they may lose their effectiveness. Finally, not addressing this risk may entrust your retirement success to luck.
To complicate matters even further, managing sequence of return risk should probably come after the retirement timing decision has been made based on other factors. These factors may include tax considerations, health care and Medicare availability and cost, Social Security claiming decisions and your personal readiness to retire.
Do you feel lucky today?
If you would like to discuss ways to reduce your reliance on luck for a successful retirement, we’d like to talk to you. Please contact us for a complimentary one hour retirement consultation.
- https://www.federalreservehistory.org/essays/great-recession-of-200709. Used only for historical data
- https://www.usbank.com/retirement-planning/financial-perspectives/sequence-of-returns-risk-impact-when-to-retire.html
- https://www.investopedia.com/terms/m/montecarlosimulation.asp
- https://money.usnews.com/investing/articles/how-to-avoid-sequence-of-returns-risk
- See: https://www.investopedia.com/terms/p/phased-retirement.asp; https://www.investopedia.com/articles/retirement/102516/rise-semiretired-life.asp; and https://crr.bc.edu/wp-content/uploads/2007/02/wob_8.pdf
- https://www.kiplinger.com/retirement/in-retirement-planning-consider-the-entire-journey
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