What is it?
Think about the year that you plan on retiring. Now, let’s think about the 5-year period before retirement and the 5-year period after retirement. This is what is known as the “fragile decade”. (You could also consider the 10-year period post-retirement.)
Sequence of return risk is the risk that comes from having negative returns on your portfolio late in your working life and/or early in your retirement life. For those retiring during a period of market downturn, the combination of negative investment performance coupled with withdrawals from your portfolio can present significant risk to the longevity of your retirement nest egg.
The tables below show the average annual returns over a 10-year period are the same. What’s different is the order of the returns, which has been reversed. Notice how much their investment value changes.
Despite having the same average annual return, Investor A has $212,533 more than Investor B due to their sequence of returns.
[Please note that the hypothetical illustration does not represent the results of an actual investment. It does not reflect any investment fees, expenses or taxes associated with investments. An average annual return of 4% is reflected for both investors. Annual withdrawals of $40,000 are taken at the end of each year.]
How to Manage the Risk?
Obviously, no one can predict the future so you never know whether your retirement timing is going to be good or bad; however, there are various strategies one can utilize to plan for this scenario. There are things that can be done in both the wealth accumulation phase and in the wealth distribution phase to mitigate this risk. For the purposes of this post, I want to discuss a few strategies that one can apply during the distribution phase.i (This is not intended to be an all-encompassing list.)
- The Static Strategy: William P. Bengen first popularized the concept of a “safe” portfolio withdrawal rate. “Using historical returns on a 50/50 stock-bond portfolio, he calculated the optimal starting withdrawal rate of 4%, therefore, to sustain a real annual income of $50,000, a client would need $1,250,000. Every year thereafter, they would adjust the previous year’s withdrawal for inflation. Like any retirement income strategy, this involves several assumptions. Bengen estimated a 30-year retirement horizon and an annual rebalance back to the 50/50 portfolio. The key challenge for retirees is rebalancing back into stocks after a large drawdown. Such loss aversion-inspired tactics could derail the strategy.”
- The Bucket Strategy: To overcome the fear of rebalancing in a down market, retirees may prefer to deploy a Bucket Strategy. The idea behind the bucket strategy is to earmark certain sums of money into accounts devoted for a certain spending stage during retirement. I recently had the opportunity to contribute to the discussion about the bucket strategy for both GOBankingRates and Yahoo Finance.
- Retirement Spending Smile: Head of Retirement Research for Morningstar, David Blanchett, CFA, CFP®, found that “clients spend earlier in their retirement, taper their expenditures in middle retirement, and then increase their outlay later in retirement. Generally speaking, retirees will consume more on travel and entertainment at first, then reduce their expenditures as their health and mobility declines. As their retirement lengthens, their health care expenses will grow and account for more of their spending.”
- The Dynamic Strategy: While the “Retirement Spending Smile” strategy lays out phases of income, a Dynamic Strategy adjusts according to market conditions. For example, if 85% is deemed an acceptable success threshold and the Monte Carlo calculates 95% distribution success, the distribution could be increased. Alternatively, if the Monte Carlo simulates a 75% probability, distributions could be cut. A 100% success rate is ideal, obviously, but it may not be achievable.
When it comes to retirement planning – especially, when you are nearing retirement – it is very important to consider the impact of various spending strategies. If this describes your situation and given these two variables, i.e. year-to-date returns of equities and the increasing inflation, then you should consult with your financial planner.
Schedule a time to discuss with Ernie Lacroix
[i] Source: https://blogs.cfainstitute.org/investor/2022/02/25/retirement-income-six-strategies/