Sequence of returns risk analyzes the order in which your investment returns occur. If you are taking withdrawals from your portfolio, the order or the sequence of investment returns can significantly impact your portfolios overall value. This is often a risk that is overlooked by many retirees. Retiring during a bull market takes hours and hours of planning. Retiring into a bear market, that is a whole other ballgame. Sequence-of-returns risk is a significant threat because retirees have little time to make up for losses that are compounded by the simultaneous drawdown of income distributions. The biggest fear that retirees have is the fear of running out of money and that is why it is important to incorporate sequence of returns risk into your financial plan.

SEQUENCE OF RETURNS RISK IN ACTION

Consider the following hypothetical investment scenarios for Ms. Jones and Mr. Anderson.

let’s look at how the sequence of returns can impact a portfolio when taking distributions: Ms. Jones and Mr. Anderson still start with an initial $1 million investment portfolio. But in this example, they start taking 5% withdrawals (of the initial value) beginning immediately at age 65. Ms. Jones begins taking withdrawals in an up market, giving her the optimal environment to maintain her portfolio value long-term. Unfortunately for Mr. Anderson, he starts taking income in a down market and depletes his entire portfolio before reaching age 83.

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HOW TO MANAGE THE RISK

Nobody knows the type of market they are going to retire into. That is why it is important to plan for all scenarios when thinking about retirement. Here are a few methods to managing the sequence of returns risk.

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DIVERSIFIED INCOME STREAMS

When planning for retirement, creating an income cash flow plan will help protect yourself from sequence of returns risk. There are a number of different ways to generate income . Whether it is creating a bond ladder, investing in dividend paying stocks, purchasing an annuity, or even considering rental properties. All of these options should be carefully planned out and put in place well in advance of retirement.

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REDUCE SPENDING

Some retirees pick a withdrawal rate and stick to it without maintaining flexibility. In times of bear markets, having the flexibility to reduce the amount of withdrawals from a portfolio will have a positive impact on your long-term portfolio. It is the compounding effect that takes place when the market falls and you are taking money out at the same time. If the market is down 3% and you take out 5%, it will take you much more on the upside to recover.

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BUCKET STRATEGY – AVOID SELLING AT LOSSES

The Bucket Strategy was popularized in the 1980s and 1990s with regards to retirement income planning. According to the bucketing approach, you separate assets into buckets of money for different time periods. You reserve more conservative assets, like cash, for short-term needs, mixed investment portfolios for the next time period and equities for the long term. The idea behind bucket approaches is to divide your retirement portfolio into several different buckets, with transfers between those buckets carefully structured.

Some people decide to hold one to two years of cash in order to meet short-term spending needs in retirement. If the market sees a big downturn, they can then spend their cash for two years to ride part of the downturn and allow their equity investments to recover.  With the bucket strategy, most use three buckets: One for cash that will be used within the next one to two years. The next is for money you will need in the next 5-10 years. The final bucket is for the money that you will need in the distant future. Each bucket contains an investment strategy that is designed to fit those time horizons, and over time, systematically refilling bucket 1 from bucket 2 and bucket 2 from bucket 3. This strategy avoids the need to panic when the market is falling and selling at the wrong time.

PLANNING AHEAD

Without proper planning, the sequence of returns early in retirement can have a significant impact on retirement outcomes. While average annual returns earned over one’s entire retirement period are critical to successful outcomes, as you can see, returns early in retirement can be just as important. Simply reducing equity exposure is an insufficient strategy, because doing so reduces the upside potential of a portfolio, and fixed-income-heavy portfolios typically support lower spending levels and have a higher probability of depleting prematurely. Creating a structured cash flow strategy for retirement will help ease the burden of dealing with sequence of returns risk and allow for a less stressful retirement.