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Sequence of Returns: Are You Playing Chicken with Your Retirement?

sequence of returns

As a child, I vividly remember playing Chicken with my younger brother. We would hop on our bikes driving straight for each other waiting to see who would be the first “chicken” and swerve away and ultimately lose the game. Of course, there were also times we walked into the house with bruised elbows and skinned knees because neither of us was willing to let the other outdo us. We were so hardheaded we chose to crash into each other.

A recent phone conversation with a client had me reminiscing that game. They wanted to know my thoughts were on the current market—especially with the recent events. Just this past weekend we saw a madman open fire on a small Texas church. Last month’s deadly rampage in Vegas stunned the world. Additionally, just this past summer, it hurricane after hurricane pummeled the gulf. So with all the chaos dominating the news, they are concerned with how these events will affect their retirement.

I am finding this question comes up quite often right now with the market reaching all-time highs. People are looking at the market and worrying that a correction is due any moment. Now I’m a proponent of letting the market do what the market does. However, there is a time to worry—that time is in the five years before retirement AND the five years after. It is often referred to as the risk of zone—a time when risks are at their highest peak.

However, the risk zone isn’t the greatest threat to your retirement in my opinion. I believe, the most significant danger lies in what is called the sequence of returns risk. Here’s how that works.

Sequence of Returns

Sequence of Returns graph

CLICK TO VIEW GRAPH

When it comes to returns, no one knows exactly what their ROI will be from year to year. We can make assumptions based on historical market returns. However, there are no guarantees in investing. And just a couple weeks ago I spoke with someone that said their planner told them their investment accounts averaged 9.26% over the last seven years. While that is good knowledge to have, it doesn’t keep you from outlasting your retirement funds. Let me break this down mathematically for you.

Look at the chart to the right. I illustrated the returns of a $2 million portfolio from 1972 all the way through 2012. Now, for those years the average rate of return was 11.55%, which is actually a pretty good return. Here’s where it gets tricky, and sequences of returns become an issue. (Please note, this is a hypothetical simplified illustration and past performance is not a promise of future returns.)

Let’s say you are accustomed to living off $170,000 a year. So we will make that your distribution. In that 40 year period, the distribution alone will come to $6.8 million. ($170,000 x 40 years). When you couple the returns with the distribution, you can see on the left-hand side that despite the negative years, the positive years allow the account balance to continue to grow. Now, had those same returns been reversed and still taking out $170,000, your portfolio runs out of money in 1989. You aren’t even a full 20 years in before you’re broke, despite having the same average of return (11.55%).

Since we NEVER know what the actual sequence of returns will be, for any given period of time, until it takes place, the key to a lasting portfolio is staying ahead of the sequence of returns risk. Knowing that it is possible to experience major losses in the five years prior to retirement and first five years of retirement, how do we offset this possibly disastrous scenario?

1. Conservative spending

Good portfolio management entails spending conservatively. If you need $100,000 a year for living expenses, then perhaps you work an extra year or two to offset that allowing your money to grow longer. The last thing you want to do is max out the spending of your retirement account in the early stages with so much uncertainty looming. Spending conservatively from the beginning means you’ll have more money later.

2. Maintain flexibility

Many times people come in and say, “I want to spend 5% of my portfolio year.” While that seems like an okay idea, the truth is depending on the sequence of returns, they end up spending all of their money, like the chart above. Instead of becoming accustomed to a particular lifestyle, be flexible. That way when, not if, but when volatility hits you won’t have to worry about whether your portfolio will dwindle out before you do.

3. Reduce volatility

You can reduce volatility a number of different ways. Perhaps you add income-producing assets. Maybe you append your portfolio by utilizing more bonds. Other retirement accounts such as a pension or annuities can create a decreased chance of volatility. Reducing volatility means you are harnessing your stability through various sources.

For example, if you are five years away from retirement, one of the things to look at is, do you have enough assets right now? Are you close enough to your goal? If so, then temper your allocation to a bit more of a conservative mix. Do you really want to try to gain another 2% to 3% of your money with the upside whenever you have the downside risk? So if you still need a more aggressive mix, then you may want to put off retirement for a few more years.

4. Buffer your assets

You avoid so many losses when you have cash involved in a portfolio; however, it can drag down performance. Notably, through rebalancing, you can use the cash position to buy low when the market drops. That allows you to ride the position back up faster—similar to riding a wave. An illustration of that would be if the market fell 20% and you had that amount invested in fixed income or cash positions. Well, now here you are a few years past retirement, and you see your income is fine. At that point, you may want to redeploy that cash to assets while the market is down. Perhaps you purchase some equities and ride the wave out of the bubble.

So buffering your assets, means the returns on your assets should not be correlated. You want to spend down various things. That’s where alternative investments can play a huge role. You are just want to be sure to create a buffering position so that whatever the market throws at you, your income is safe.

What Does This All Mean?

Realize no one controls the sequence of returns—NO ONE! You may have an idea of when you want to retire, but not know the exact date or if you will even make it to retirement. We just honestly have no clue. So don’t focus on averages, know that the sequence of returns matter, especially when you enter that red zone, which is that five-year period before and after retirement. That is the time to be concerned with what the market is doing.

Don’t get caught up in the antics. When talking with your planner ask for a Monte Carlo analysis. This will give you multiple scenarios and the hypothetical returns within those. It will show you the various sequence of returns within each scenario. Focus on getting your portfolio distribution rate somewhere between 75% to 85% successful in all of the various markets within the analysis. If you do that, then you should be able to weather any volatility that the market may throw at you. If you have questions, we can help. Contact us to help make your portfolio management financially simpler. 

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