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It Is All About Timing – Impacts from Sequence of Returns Risk

The ongoing Coronavirus pandemic has had devastating and worldwide impacts on all facets of life. The virus has caused the loss of human life and the suffering of people around the world. While not meaning to belittle the human toll, the virus has also had a deleterious impact to the economy and to people’s retirement savings. In a little over a month, the Dow Jones Industrial average dropped over 38% from its high to the recent market lows. While market downturns are expected and even necessary to maintain an efficient and healthy market that does not relieve the trepidation that many feel when in the midst of a downturn like we are currently. The recent events’ long-term effect on one’s retirement portfolio savings is dependent on many things, none more important than timing.

One of the Merriam Webster definitions for timing is "the ability to select the precise moment for doing something for optimum effect." The importance of good timing is important in almost all aspects of life but maybe none more so than when it comes to investment returns. This can be especially true when it comes to the sequence of returns for those in or about to enter retirement. The timing of market returns can have a devastatingly negative or extremely positive impact to your retirement plans. Let’s take a look at some illustrations to better demonstrate this.

In the above example, both clients’ portfolios started with $1,000,000, averaged 7% returns over their retirement and finished with the same dollar amount. Even though the individual annual results were different, the value was identical at the end of the plan since the average annual return was the same and there were no additions or distributions. 

A more real-world example is taking distributions from portfolio holdings during your retirement. In the below example, both clients are taking an annual 5% distribution (of the original holdings amount) and the results are as follows…

In the “Up” market example, the client is able to take the distributions without depleting the principal because the market return in the initial years is greater than the withdrawal amount. In the “Down” market example, the initial downturn in the market combined with the distributions causes this client to deplete the entire account balance by age 83. Even though the 25 year average return was identical, the sequence of investment returns significantly impacted the portfolio in the “Down” market when taking distributions. Why does this happen? Because of the significant reductions in the portfolio during the three initial years of retirement, there is insufficient portfolio value remaining to benefit from the positive returns in 10 of the last 11 years.

If you have ever turned on any of the financial news channels, you have heard finance professionals chanting the mantra that you cannot time the market. So what can be done for those about to enter retirement to help mitigate any potential sequence of returns risk?

One option is to take money out of the stock market by setting it aside to use specifically for spending during the initial years of retirement. One of the ways to set aside money specifically for spending in the initial years of retirement is to create a laddered bond portfolio, so that each year a bond matures to meet your cash flow needs. The number of years to set aside can be determined through discussions with clients regarding risk tolerance and the projected retirement time horizon. Not having to withdraw funds when the market is down allows you to avoid the negative compound interest effect in a declining market. Avoiding the negative compound interest effect greatly increases the likelihood of not outliving your money.

Another option is the bucketing strategy. This approach separates assets into buckets of money for different time periods. For the short-term needs bucket you would include conservative assets like cash, mixed investment portfolios for the intermediate time period and equities for the long term. Having equities in the long-term bucket helps to mitigate sequence risks by not having to sell those assets to meet  spending needs during a downturn in the market thus allowing time for asset values to return in improved market conditions.

A third option is to use the equity in your home. The average retirement age couple has the majority of their wealth in their home. Utilizing home equity with a home equity line of credit or reverse mortgage in order to provide cash in a down market can help you avoid liquidating assets at an inopportune time. However, these options are not for everyone and must be weighed carefully and considered in connection with the overall plan. 

Currently, we are in the midst of challenging and in many ways unprecedented times. However, as far as the market is concerned, we will see things improve as they have always done following other major downturns. No one can say with certainty when this will occur but it will occur. The key is to be prepared with a plan. Helping clients create their plan is what we do and we do it well. Please reach out if you have any thoughts, questions or concerns.