In plain English, sequence of returns risk means that if the stock market plunges at about the same time you retire and start taking regular withdrawals from your primary investment account, you could be in for a big financial shock. That’s because an investment portfolio exposed to stock market losses early in retirement, and then further diminished by regular retirement withdrawals, could run out of gas far earlier than you had planned.
This double-dip isn’t just theoretical. It’s playing out in real-time as recent retirees have watched the value of their investment accounts drop sharply in the wake of the COVID-19 outbreak. But there are antidotes to this unfortunate timing. One, of course, is to delay retirement, but if that’s not realistic, there’s another way to shield your portfolio from sequence of returns risk.
Let’s see what that is as we take a deeper dive into what sequence of returns risk is, how it could impact your portfolio, and how you can better defend against its ravaging long-term effects.
What goes up can go down
Research shows that the average long-term return for the Standard & Poor’s 500 is about 10%. The keyword is average. As any investor knows, market returns run the gamut. For example, in 2019, a very good year for stocks, the S&P was up 31.1%. But in 2008, the same index was down 37.22%.
The almost 30% drop (Feb. 12-March 12) in the S&P 500 means that if you had a $1 million equity portfolio, it could be worth about $700,000, a significantly smaller nest egg from which to draw. The value of this portfolio would be even less if you were simultaneously pulling out money to live on, according to your retirement withdrawal plan.
Take a further look at how this plays out in this chart from Baird Financial Advisors.
As you can see, both portfolios averaged 6% returns over the course of 25 years. But by making 5% withdrawals, Mr. Brown’s portfolio, which experienced declines in the first three years of retirement was depleted in less than 20 years. Mr. Green’s portfolio, on the other hand, which enjoyed positive returns in the first few years, continued to grow.
What can be done?
A certain amount of volatility is always to be expected when you’re investing. If you want your money to grow, you must accept a certain amount of risk, too.
But an ounce of prevention goes a long way, too. In an ideal world, you have taken steps to create a well-diversified portfolio appropriate for your risk tolerance and time horizon, including some fixed-income (bonds) and perhaps alternative investments to balance out your equity positions because those assets typically don’t move in lockstep with stocks. But, in truth, retirement accounts that may have started with a fairly modest 60/40 stocks-to-bonds split at the start of the 11-year bull market in March 2009 may not have maintained that balance by the end of the run in March 2020, the longest in U.S. history. In fact, Vanguard, the large mutual fund company, found that in a survey of 44,000 do-it-yourself investors, the average bond position was just 23%, closer to a far more aggressive 80/20 split.
If you’re planning to retire in the next five years…
While you may not have immediate plans to tap your portfolio, make sure your portfolio isn’t overly exposed to sequence risk. Here’s how:
The goal behind the bucket strategy is to protect you from drawing down assets from your primary retirement before they have had a chance to rebound. Having a separate or alternative bucket filled with low-risk or conservative assets, minimally or not at all affected by market volatility, allows you to pursue this strategy.
Set up a reverse mortgage line of credit
Research by economists Wade Pfau, Barry Sacks and Jon Salter, who have extensively studied sequence of returns risk, suggests that setting up a reverse mortgage as a line of credit early in retirement (you must be at least 62 years old to obtain a reverse mortgage loan) can improve the longevity of a portfolio. Retirees can use the line of credit for their cash-flow needs during market downturns and allow their portfolio to recover. Consider setting up the line of credit now so it’s available to you in retirement.
If you’re planning to retire in the next year…
With retirement on the horizon, you may be thinking about how to avoid dipping into your nest egg when the time comes. One option is to delay retirement. You may not need to work full time to earn enough money to meet your living expenses. Ask yourself if you can take on consulting work or participate in the gig economy to bring in extra income?
If you’re already retired….
When you’re already in a drawdown mode, you might have less flexibility about tapping your nest egg. Yet you’re not defenseless. Consider these steps:
Reduce your lifestyle: It’s simple math. The less you spend, the less you need to withdraw from your portfolio.
Use a reverse mortgage loan: If you’re over 62 and have significant equity in your home, you may be able to use a reverse mortgage loan to improve your cash flow. By turning to this source of tax-free funds, your portfolio will have time to recover. Although you are not required to make a monthly mortgage payment, which gives you greater cash-flow flexibility for managing your retirement, you are still responsible for maintaining your home and paying your property taxes and homeowners’ insurance.
There is no silver bullet when it comes to preventing and avoiding sequence of returns risk. But being mindful of how you approach your retirement income withdrawals — especially early on when one or two down years can jeopardize the longevity of your portfolio — can help you see more sunny days ahead.
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.