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What is “Sequence of Returns Risk” and Why it Matters

What is “Sequence of Returns Risk” and Why it Matters

August 20, 2021

What happens to your portfolio in the first few years of retirement has an outsized impact on your financial plan.

Everyone worries about how market movements may impact their portfolio.  But those who are very close to, or have just recently started, retirement have perhaps the most cause for worry.

Those who are earning, saving, and accumulating assets would do best to follow the age old advice of “just shut your eyes and ignore” the market movements.  In fact, a downturn in stocks for someone who is adding to their portfolio can be a blessing in disguise.  It allows them to purchase shares of their investments “on sale” during the downturn – which may very well enhance the investor's returns once the market recovers.

Early retirees or those just about to retire, however, can suffer from the opposite effect.  Taking distributions from a portfolio that has been suddenly impacted by a prolonged downturn means that the investor has to sell investments at a low price.  Taking those assets out of the portfolio means that there is less money available when the recovery occurs, making it harder for the portfolio to recover as stocks bounce back.  This can have significant impacts to those who still face 20 or 30 years of distributions to fund their retirements. 

Not all market downturns are created equal

It is important to note that not all market downturns are created equal, and not all retirement plans are equally exposed to this risk.

Short lived downturns such as we experienced in late 2018, or the very short lived Pandemic Panic of 2020 really have very little impact on the longevity of a portfolio.  Since these downturns lasted a very short time, an investor taking monthly distributions would have had to sell only a small portion of their portfolio at depressed prices.  In both these cases, markets came roaring back quickly. 

In contrast, the 2008 financial crisis was much longer lasting.  Stock prices took 18 months to fall to their nadir in March 2009.  From that point they recovered ground fairly quickly, but someone retiring in early 2008 would have had to sell stocks at depressed prices for years. 

Even more problematic would have been an individual retiring in early 2000.  Stocks were depressed for several years before beginning to recover in 2004…and then after a few years of gains investors had to face the 2008 crisis. 

So what should a retiree do to limit sequence of returns risk? 

Well first, of course, create a sound financial plan to determine how exposed you really are.  For instance, an investor with a very well funded retirement may have very little to worry about.  Such an investor may choose to remain rather aggressively invested knowing they can afford to accept the risk.  On the other hand, if the math on your financial plan is marginal, that is, if you just have enough to squeak through retirement without much margin for error – you need to pay close attention to this risk.  Our financial planning software can run various stress tests to indicate the degree to which a sudden stock market return could impact the longevity of your portfolio. 

What can an investor do to limit the risk to their plan?  First and foremost is to make sure that your asset allocation is appropriate based on your financial plan.  Running away from stocks altogether may reduce your sequence of returns risk, but it will expose you to another insidious force – that of inflation.  Without the higher potential long term returns provided by stocks, you may find that you do not have enough resources to keep up with the rising cost of living!  So are you “damned if you do and damned if you don’t?”  Not really.  The trick really is to weigh and balance all of the risks you face.  Own stocks, but don’t overdo it (unless you can afford to weather the potential losses).  

Another strategy may be to incorporate other income sources.  For instance, an early retiree who has not yet started their Social Security benefit may choose to claim that benefit early to reduce the pressure on their investment portfolios.  Yes, I know, prevailing wisdom says wait as long as possible - but the benefit of waiting is not the same for everyone, and is often overplayed by the media. (Useful Tip:  The 8% increase in your monthly payment you receive for waiting one year to collect IS NOT the same as earning an 8% investment return despite what some in the media will write.  They need to go back to 3rd grade and study their arithmetic!)   The same may apply for retirees who have been waiting to claim a pension benefit.  Retirement income sources such as pensions can significantly reduce sequence of returns risk since they reduce the need to draw on investments during hard times.   

Should I just get out of stocks to reduce my risk? 

There is a strong temptation to try to outsmart the markets here.  For instance, many investors nearing retirement when markets are strong (as they are today) will argue that they should get out of stocks "while they are high".  This rarely works, unless you are prepared to retire on fixed income style returns for the rest of your life.  And if you have enough money to do that, you can probably afford to remain in stocks anyway and weather any potential downturn.  "Getting out of stocks" begs the question of "when will you get back in?".  Assuming there will be a  lower point of entry is problematic.  Many investors were panicky in 2015 as markets reached all time highs.  The investor who sold out to contain his risk never actually experienced a reentry point, and may now be earning 0.05% on his money market account.  Even if a reentry point does occur - lets use April 2020 as an example - what retiree has enough guts to jump into the market at that point?  Those who were properly allocated and stuck with their plans may have experienced occasional downturns along the way, but those dips should not threaten their retirement plans.  Attempting to "time the market" by jumping in and out introduces another whole level of risk, and one that is almost impossible to manage or control.  

Rules of Thumb are No Substitute for Professional Advice and a Financial Plan.

There is no one size fits all solution here.  Old rules of thumb such as “own a percent of stocks equal to 110 minus your age” are not helpful in the real world.  For one, it ignores the overall level of wealth, as well as differences in goals.  For instance, such a rule of thumb implies that a 90 year old should only have 20% in stocks.  But many 90 year olds who still have sizable investment portfolios are more interested in passing their wealth along to their kids than accumulating for their own spending!   Not only that, but a 90 year old with a much shorter life expectancy over which to withdraw funds actually faces a much lower sequence of returns risk than does a 60 year old who just accepted an early retirement package!  

The prescription requires good sound planning and customized investment advice, rather than rules of thumb and cookie cutter solutions.  That is what we at Financial Pathways specialize in.  So if you haven’t created your financial plan yet, now is the time to get started.  And if you haven’t updated your retirement plan in a while – give us a call.  The best prescription for worry and stress is a sound plan. 

Remember, investing involves risk of loss.  Past performance is no guarantee of future performance, and asset allocation strategies, while they may reduce risk of loss, do not eliminate such risks.  Furthermore, asset allocation strategies are not equally effective in all market climates.