Stonegate in The News and Blog Posts

Retirement should be the time when you are less stressed and should have fewer worries, after all you no longer have the stress of the commute or your job. Many find those worries replaced with others including fears they might run out of money or be forced into a diminished lifestyle. Those fears are justified; inflation increases your expenses and diminishes the value of any fixed income you receive, health care costs are a great unknown, or you may live much longer than predicted increasing the chance you could outlive your resources. Guarding against some of those dangers by having the correct mix of assets to provide enough growth without taking on excessive risk may be challenging.

The risk that you might outlive your assets may be dramatically increased if you happen to retire at the “wrong” time. What happens for example if your timing is poor and you just happen to retire before a market decline?  What does that mean for your portfolio? A declining market combined with the withdrawals you may need to make to create that “retirement paycheck” will put a severe strain on your portfolio and dramatically increase the odds that you may run out of money especially if you live for 20 or more years in retirement.

This risk, commonly called “Sequence Risk” or order of return risk (bad timing combined with withdrawals), is a risk that can devastate the portfolio of retirees.

An example will make it much clearer:

If you retired in 1996 and had a portfolio of $100,000 all invested in an S&P 500 index you would have experienced the following sequence of returns.

• 1996 – 23.10%
• 1997 – 33.40%
• 1998 – 28.60%
• 1999 – 21.00%
• 2000 –   (9.10%)
• 2001 – (11.90%)
• 2002 – (22.10%)
• 2003 – 28.70%
• 2004 – 10.90%
• 2005 –   4.90%

If you were withdrawing $6,000 per year to meet your income needs in retirement your portfolio would have grown to $162,548 and your withdrawals would have been $60,000 for a total of $222,548.

Now consider an alternative universe where the order of returns is reversed as follows:

• 1996 –   4.90%
• 1997 – 10.90%
• 1998 – 28.70%
• 1999 – (22.10%)
• 2000 – (11.90%)
• 2001 –  (9.10%)
• 2002 – 21.00%
• 2003 – 28.60%
• 2004 – 33.4%%
• 2005 – 23.10%

With the same $100,000 portfolio and annual withdrawal of $6,000 your portfolio would be worth $125,691, combined with the $60,000 in annual withdrawals it totals only $185,691. Now the $6,000 withdrawal represents 4.8% of your portfolio instead of 3.7% in the original scenario. If you were not making withdrawals the sequence would not have mattered, your portfolio would be worth the same with either pattern of returns, $238,673. There is no impact if you are not making withdrawals. (People in the “accumulation” phase of their life may benefit from dollar cost averaging.) It is the timing of the withdrawals that particularly impacts prospects for your invested assets. Selling an asset that has declined in price dramatically limits your ability to capture the upside during market recoveries. Managing sequence risk means you need to try to avoid the sale of asset classes that are in the throes of a bear market. Here are some suggestions:

Have enough in fixed income (bonds) –  If you have a portfolio of $1,000,000 and need to withdraw $40,000 each year, have enough in bonds to guarantee the $40,000 is available for 7-8 years in case a bear market is very severe. That means having no more than 70% of your portfolio in riskier, growth assets.

Reduce your withdrawal rate –  Manage your discretionary expenses so you can reduce the demands on your portfolio until the market recovers. There are various rules based approaches we’ve studied.

Have more recurring income through your Social Security claiming strategy or by buying immediate income annuities –  Delaying Social Security till age 70 may dramatically increase your monthly income. Turning some of your portfolio into a steady income stream by annuitizing it can enable you to invest differently since you know you have a safe income floor.

Consider a Reverse Mortgage –  Establish a Home Equity Conversion Mortgage (HECM) early on in retirement to act as a backup source of funds to tap during market declines.

We will discuss these strategies in future blogs.

Understanding your exposure to “Sequence Risk” and having a strategy to overcome it may be critical to your retirement.

Stephen C. Craffen, CFA

Interest rates have been low for years, dramatically impacting anyone who must hold a large position in cash.  There may be several reasons why you need to hold a large cash position, perhaps you have some anticipated large expense looming, or you need to have a large cash reserve for an emergency. You might have thousands of dollars in cash, earning .25% in a money market account. Can you earn more?

Here are some of the investments you might consider and why they may not be good choices.

Floating Rate Loan funds – are funds that invest in bank loans, very often those that are below investment grade. Right now, some of these funds have yields that range from 4-6%, a huge improvement over a money market fund. Unfortunately, these types of funds are subject to more risk than one would expect. In 2008 when markets were crashing some of these funds also declined in value by 25-30%. During a financial crisis, the default rate for the loans these funds hold can also skyrocket and impact return. Exposure to that amount of risk is not what you want for your cash reserves.

High Yield Bond funds – High yield bonds are generally considered to be bonds that are rated BB or lower by S&P or Ba by Moody’s. They have historically provided high income over the years. Like every other class of bond, yields are now low when compared to their historical yield; yet their risk has not decreased. Like floating rate loan funds, in 2008 high yield bond’s return was -28%, illustrating how risky this asset class is during economic slowdowns or financial crises. Like floating rate loans their default rate also tends to rise dramatically during recessions.

Longer Term Bond ETF’s – May have a much higher yield than a money market account but they come with much greater risk not from defaults (for government bond funds or high-quality corporate’s) but instead from increasing interest rates. The market value of the bonds they hold can be quite sensitive to interest rate changes. For example, Vanguard’s Long-Term Government Bond ETF (VGLT) lost 1.8% for the prior year ending 5/31/2017. That includes it’s yield which is around 2.7% right now.  If interest rates rise long term bond funds can easily have negative returns as high as 6% in one year, since the bonds they buy may decline in value that much or more for each 1% increase in interest rates.

Preferred Stock Funds – Companies may issue several classes of stock including common stock and preferred stock. Preferred stock is issued with a fixed and typically high dividend, right now yields are in the 4-6% range. If a company is liquidated preferred shareholders receive whatever is left after bond holders are reimbursed but before common stockholders. Preferred stock has much of the risk of common stock since it is effectively an unsecured debt (unlike a bond) but it lacks the potential for growth since the dividend is fixed and the preferred stock may also be callable. Because of these features we do not believe it is a good investment for most people. In a bad market, preferred stock acts like common stock. In one case, an ETF that invests in preferred stock dropped 61% from May 2007 to March 2009.

While this list is not complete, we hope we’ve given you a feel for the risks you may encounter in trying to get more yield.  You increase your exposure to types of risk that generally do not exist with a money market account. Those risks in summary include, market risk, interest rate risk, and default risk. When we consider these options, I recall something a professor wrote on the black board when I was getting my Masters in Finance: TINSTAAFL. None of us could guess what the heck that meant until he told us: There Is No Such Thing as A Free Lunch.

Stephen Craffen