When we retire and the paychecks stop, we need to rely on alternate sources of income to pay our bills and fund our retirement lifestyle. For most, that means Social Security or an employer pension. Social Security and some pensions provide only a small portion of our working income and aren’t enough to fully fund our retirement expenses. That’s when we turn to our savings and investments to close the income gap and live the lifestyle that we’ve dreamt of and, hopefully, planned for. How long our savings and investments last depend on many factors. One important factor that many investors don’t realize, or understand, is the impact that investment returns have on the longevity of our money, especially at the beginning of the Distribution Phase of life. When we retire, we transition from the Accumulation Phase of our lives to the Distribution Phase. In other words, we switch from saving a portion of what we earn to withdrawing what we’ve saved. Selling investment holdings and distributing the proceeds during a falling market is, like the old cliché says, “catching a falling knife”.
The order in which investment returns occur, known as Sequence of Returns, should be considered when deciding when to start taking distributions from retirement and other investment accounts. Obviously, the order in which investment returns occur is uncontrollable, but it matters and should be considered, among many other things, when planning your exit from the workplace and the beginning of withdrawals. Why does it matter? Because the losses realized selling investments and taking withdrawals during a falling market may be extremely difficult to make up later.
Sequence of Returns doesn’t matter during the Accumulation Phase, average investment return matters. However, Sequence of Returns is the major risk when we enter the Distribution Phase of life. In fact, the Sequence of Returns early in the Distribution Phase can have a devastating impact on the principal of an investment portfolio. Poor returns and withdrawals early in retirement can do lasting damage to a portfolio that can be very difficult, or impossible to overcome. The good news is that the impact of Sequence of Returns diminishes over time, especially when positive returns are realized early.
To illustrate the importance of Sequence of Returns risk, the table below assumes a hypothetical scenario where Alan and Brian are both taking a 5% income stream of the starting portfolio value of $662,424, or $33,121.20/ year at age 65, and increasing that amount by 3% every year to keep pace with inflation. We will also assume that they will live until age 90 and will earn the exact same returns in their distribution phase as they did in their accumulation phase. However, unlike the Accumulation phase, Alan ended with $2,413,577 at age 90 while Brian ran out of money at age 79! How can this be?
The above hypothetical example is provided with the permission of its author, Liberty One Investment Management. The content is for informational and educational purposes only. Nothing presented herein is or is intended to constitute investment advice or recommendation to buy or sell any type of securities and no investment decision should be made solely on the information provided. All investment strategies involve risk of loss, including principal. Before investing, consider the investment objective, risk tolerance, potential for loss of principal, fees, and expenses.
The drastic difference between Alan’s and Brian’s results can be explained by the Sequence of Returns risk. Alan started his retirement with three great years while Brian started his retirement with three bad years. Keep in mind, they are both taking out an inflation adjusted withdrawal every year based off their original 5% withdrawal figure. This means in Year 1, not only is Brian withdrawing 5% for income purposes, but his account also lost 13% of its value, further depleting the account. It is the same story again in Year 2.
Brian is withdrawing more income this time and his account lost value again. When this happens, the problem compounds and it becomes very difficult for Brian to catch up to where he wants to be. The damage is done, and Brian will run out of money at age 79 if he doesn’t adjust or lower his withdrawals. Alan on the other hand earned great returns in the first few years of retirement. In fact, his portfolio earned more than the 5% withdrawal rate he was taking. This allowed the account to continue to grow and the account balances between Alan and Brian are drastically different after just 5 years.
Since we have no control over the timing of the Sequence of Returns, how can an investor prepare for it? Should an investor wait for a raging bull market to retire to reduce the Sequence of Return risk? Maybe, but I think there is a more realistic way to prepare. First, don’t make the mistake of thinking that the transition from the Accumulation to the Distribution phase is a one-time event occurring on the day someone retires. Rather, it’s a transition that should be phased in over several years. My personal belief is that an investment portfolio should evolve with time as an investor moves closer to retirement. Investments must be reviewed over a full market cycle, with an emphasis on periods of significant declines, to evaluate the investments’ ability to provide upside opportunity and downside protection. This is where a trusted advisor can be an invaluable resource. I know the do-it-yourself industry may disagree, but the average investor, busy building a life, doesn’t possess the tools or the understanding of how to do that effectively. It takes more than buying a nearly free index fund to prepare for a 30- or 40-year retirement, and the Distribution Phase.
Here are 4 tips for potentially reducing the Sequence of Returns risk for someone within 5-10 years of retirement:
Begin to focus more on total return as an investment objective rather than a pure growth objective. Total return combines the elements of growth with investment income, or dividends. Focus on quality companies, with a track record of not only paying a dividend but increasing that dividend often. Reinvest all dividends to accumulate shares of quality companies until the dividends are needed. Great companies that potentially increase their share price and dividend rate create Total Return.
Don’t panic during inevitable stock market volatility. The end goal should be to build a high-quality, total return source of both growth and income. Remember that dividends are based on the number of shares owned, not the value of the shares. View short-term stock market volatility as an opportunity to buy more quality at a lower price to build a total return portfolio.
Notwithstanding the above, don’t ignore what the markets are telling us during periods of extreme volatility. Utilize strategies designed to analyze data and eliminate emotions to make investment decisions. Don’t simply “ride it out” during a severe market downturn. There are ways to protect the downside.
Create alternate sources of retirement cash flow to hedge against Sequence of Return risk when you retire. These alternate sources of income include life insurance cash value, annuities, bonds, and cash allocations to name a few.
Sequence of Return risk is dangerous and can shatter a lifetime goal of a comfortable retirement. Like all risks, it can’t be completely avoided or accurately timed. However, steps can be taken to hedge against it and minimize its impact. Seek out an experienced advisor to discuss your plan to reduce exposure to Sequence of Return, and other risks that can derail your dream of a secure, comfortable retirement.
Live Well-Retire Better™
Live Well-Retire Better™ is a non-traditional financial planning process that was developed based on my philosophy that you don’t have to choose between enjoying the pleasures of life while working and saving for a comfortable retirement. Although nothing is guaranteed, with commitment, discipline, and careful planning, you can enjoy the comforts of life now, AND when you retire.
If you’d like to talk about The Live Well-Retire Better™ method of financial planning, or have questions or concerns, please set up a call. There is never a charge or any obligation for an introductory conversation.
For a comprehensive review of your personal situation, always consult with a tax or legal advisor. Neither Cetera Advisors LLC nor any of its representatives may give legal or tax advice. All investing involves risk, including the possible loss of principal. There is no assurance that any investment strategy will be successful.
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