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