Sequence of Returns Risk: How It Impacts Retirement

May 11, 2020

On Feb. 12, 2020, the Dow Jones Industrial Average (DJIA) closed the trading day at a record 29,568.57. If you were an investor in the market and a fan of Abraham Lincoln, on whose birthday the new high was achieved, you had big reasons to celebrate.

However, on March 23, 2020, just 40 days later, the DJIA closed at 18,213.65, a breathtaking fall of 38.4%.

If you blamed the crash on a convergence of forces — the onset of the COVID-19 pandemic and a sharp decline in world oil prices — you wouldn’t get much of an argument. But the real focus should not be on what caused the most recent crash, but on the recognition, that market crashes are not outliers or once-in-a-century events. They occur every decade or so. There was the Black Monday market crash of 1987, the dot com crash of 2000, and the Great Recession and credit crisis of 2008, just to name a few market upheavals.

Now imagine if you had begun your retirement about the same time as any of these market downturns, including the current one. Your investment portfolio would have been seriously damaged. And the destruction would have been made worse if you were regularly drawing from your account to pay for your everyday living expenses.

This unfortunate timing — the market diving early in your retirement — is known as sequence of returns risk. This phenomenon is perhaps best illustrated with an example inspired by Kiplinger’s that compares the investment performance of two similar seniors whom we will call Dan and Ann. Over two different four-year periods, both Dan and Ann averaged an overall 3 percent return on the $1 million that each started with at the beginning of their retirement. Each also withdrew $60,000 each year to live on.

Note: The annual withdrawal rate of $60,000 (6%) cited in the example is for illustration purposes only. Many retirees use a more conservative rate of just 4% as a rule of thumb to help their savings last longer. Choose a withdrawal rate you’re comfortable with in conjunction with your financial advisor or other trusted financial professional.)   

Despite starting retirement with the same amount of money, averaging the same rate of return, and withdrawing the same amount of money each year, Dan had only $720,000 remaining in his retirement fund after four years while Ann had $831,768 — a $111,768 difference.

Sequence of Returns Risk Explained

How could that happen? The one-word answer is “timing.” In the fourth year of Dan’s retirement, he earned a 25 percent return, whereas Ann realized a 25 percent return her first year. Overall, Dan’s retirement fund performed poorly in the beginning before finishing strongly while Ann’s fund started strongly before finishing poorly. 

The clear takeaway from this example is that while the total rate of return on your account matters, what matters even more is the order or “sequence” in which you receive those yearly returns. The data show that you want your best returns upfront, not late in the game. Ideally, you want your retirement to start in a bull market, not a bear one. To use a comedic metaphor, you don’t want to bomb with your first joke! Save those ho-hummers or downers for later in your retirement act, when they will be less destructive to your performance.

Okay, great, so we know that we need to combat sequence risk, because a down market can happen at any moment. The unfortunate thing is, crystal balls and fortune tellers haven’t been proven methods of gaining insight into the market. We really need to adopt a holistic retirement strategy keeping Murphy’s Law in mind: “Anything that can go wrong will go wrong.” So, before calling it quits in the workforce, it’s best to have a plan in place assuming bad years can happen at ANY TIME throughout your retirement. Keep it simple, too. Think two or three years into retirement. What plan of action will you take if those early critical years don’t produce the gains needed for a sustainable retirement?

Ideally, the best time to prepare for sequence of returns risk is before you retire. It’s a lot easier to get all your ducks in a row while the waters are still calm, not after market conditions have turned choppy. Because we know you can’t control the market, let’s focus on the things you can control in order to ensure your investments have the best chance at a solid return.

Below are three strategies you can put in place early in order to combat potential losses:

Strategy 1: Build a bond ladder

To cover your income needs over the first five years of retirement, you could create a bond ladder, which is a portfolio of bonds with different maturities. For example, one bond would mature in a year, a second in two years, a third in three years, a fourth in four years and a fifth in five years. If interest rates and bond yields have decreased by the time that you’re ready to purchase your next bond, you wouldn’t generate as much income as before with the same amount invested in a similar quality bond. Conversely, if rates and bond yields have risen, you would generate more income with your next purchase. Staggering your bond purchases is a way to reduce reinvestment risk.

Strategy 2: Insure your investments

There are two main categories of guaranteed insurance contracts (GICs), life insurance and annuities, which can help protect your primary retirement portfolio.

With an insurance policy, such as whole or universal life policy, you are buying a permanent policy that lasts your entire life because these policies build “cash-value,” money you can take out while you are still alive. The downside with this insurance strategy is that it can take several years to build cash value.

An annuity is a type of savings contract designed to turn your savings into payments for the future, for instance, you’re receiving $500 a month for 20 years. You can purchase an annuity with a lump-sum payment or pay in installments before retiring.

In a stock market downturn, use the money from either your insurance policy or annuity as a buffer asset to help cover your retirement expenses until the market rebounds.

Strategy 3: Access home equity

For many homeowners, the home itself is their largest asset. In fact, housing wealth among Americans 62 and over has risen to a record $7.23 trillion (according to NRMLA). So, how can you use that built-up equity and appreciation to mitigate market volatility?

Maybe the savviest way, if you are 62 or older, is to open a reverse mortgage line of credit, one of the payment options you can select with a reverse mortgage.

This option offers several advantages. First, you are charged interest only on the portion of the line you use. Second, the amount of the line you don’t touch continues to grow year after year.

Let’s say, you had a reverse mortgage line of credit already open. You could pull from it during the current downturn until the market rebounds. That way, you won’t be forced to sell stocks to generate the money you need to live on. And when the market recovers, you can pay down the line or you can wait to pay it off when you leave your home. That’s the beauty of a reverse mortgage. It doesn’t have to be repaid until you leave your home, provided you continue to maintain and pay property taxes and homeowners insurance on your home. Of all your reverse mortgage payment options, the line of credit gives you maximum flexibility and a growth feature to help you manage your financial affairs.

Besides opening a reverse mortgage line of credit, you also have the option of receiving your tax-free payments over a set number of years (term), for life (tenure), or you can receive much of your equity upfront (lump sum) the first year. With any of these options (including a line of credit), the amount of money you’ll need to withdraw from your retirement fund to cover expenses is drastically reduced. That’s because a reverse mortgage requires no monthly mortgage payments. You are still responsible, however, for complying with your loan terms, which include maintenance of the home and payment of your property taxes and homeowners insurance.

Let’s say your mortgage is $1,000 a month—now imagine having an extra $12,000 in savings each year.

Bull markets don’t run forever, and if they happen to stop at the start of your retirement, the savings you were counting on for a long retirement could be in jeopardy because of sequence of returns risk.

There are several ways to reduce or offset this sequence risk, but no plan is perfect or without costs of their own. For instance, there are origination, closing and insurance costs associated with setting up a reverse mortgage. Similarly, you will pay fees, commissions or other charges for purchasing annuities, bonds or other investments. The key point is, you need to know what these trade-offs are.

Also keep in mind that if your retirement savings are all invested in a retirement account like a 401(k) or IRA and you are older than 70 ½, you typically are required to begin taking required minimum distributions or RMDs. (The CARES Act has delayed the RMDs for one year.) These mandatory distributions, especially if they have been invested in growth vehicles like common stocks, will minimize the upside or advantage of pulling funds from other financial buckets to reduce sequence of returns risk.

Your pending retirement will give you a lot to think about

Your pending retirement will give you a lot to think about and plan for, so be prepared to run various scenarios with your trusted financial planner or tax advisor until you arrive at a strategy that you believe will give you the greatest protection for your retirement.

We hope this article has given you some help with things to think about. Of course, every situation is different. This information is intended to be general and educational in nature, and should not be construed as financial advice. Consult your financial advisor before implementing financial strategies for your retirement.


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