Sequence of Return Risk and Planning for Your Retirement Future
Recently, a client of mine came in to see me and said he was ready to retire. He had crunched the numbers. He knew his expenses. He reviewed his portfolio value. And he believed he was in good shape.
He had a $2 million portfolio and needed $90,000 a year to live comfortably. That is slightly more than a 4% withdrawal. We both believed 5% market returns over the long run were achievable--even in today’s economy.
After I reviewed the numbers with him, I told him I was uncomfortable with pulling the trigger on retirement today.
With all of his retirement income being in the markets and no pension or annuity income, I felt that he had a significant sequence of return risk.
Essentially, just because the average return on a portfolio (5%) is above the expected withdrawal rate (4.5%), that does not mean the money will last through retirement. Starting retirement off in a bear market can absolutely devastate the longevity of a portfolio, while starting off retirement with a bull market can pay off handsomely.
As viewed in the chart below, this is because the order in which the returns to a portfolio occur really matter for a retiree taking income from the portfolio.
Who is Subject to Sequence of Return Risk?
This risk is especially prevalent for families who have a large majority of their retirement income subject to market returns. I see this all the time with retirees who choose the lump-sum pension option. They have a bucket of money to invest, which often times makes them feel comfortable. The problem is that without careful planning they may be setting themselves up for failure.
Sequence-of-return risk can often be compounded by retirees' psychological reactions to the market in early retirement. Quite frequently we notice that retirees watch the market with greater scrutiny in their first few years outside of the office and are much more likely to react to market volatility. Now that they are living entirely off of their savings, their gut instinct will often be to “protect” their portfolio when the market is fluctuating by selling equities and going to cash exactly when they should be doing the opposite.
What Can Be Done to Mitigate Sequence of Return Risk?
For some, taking a pension as an annuity or buying an equivalent product may be a choice to reduce the amount of their asset base that is subject to market risk. Of course, annuity pensions simply trade off one type of risk for another. For many clients, we suggest a cash reserve to cover short-term expenses. Often knowing that the next 2-4 years are covered without being forced to liquidate a portion of the portfolio in a potentially bad market will often help retirees sleep better at night. (At the same time, holding too much cash can also be a problem, especially considering how long retirees are living these days.) Though, in the particular situation of the client that was recently in my office, I recommended a few more years of work before retirement.