As 2007 drew to a close, many Americans eagerly anticipated their upcoming retirement dates. After all, roughly 10,000 Baby Boomers retire daily. But by the end of 2008, many of the people who did decide to retire that year probably wished they hadn’t.
The S&P 500 fell 37% over the course of the year, significantly eroding their retirement savings and digging them into a hole that would be tough to climb out of.
This experience illustrates the perils of sequence of returns risk, which occurs when the market’s returns at a specific time are unfavorable, even if that volatility averages out into favorable returns during the long term.
Sign up for Kiplinger’s Free E-Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
This type of risk is particularly devastating to retirees when it occurs early in retirement. That’s why people need to be aware of a number of factors as they contemplate retirement, including how sequence of returns risk works, the market backdrop during the run-up to retirement and retirement income strategies that can counteract this risk.
How This Risk Factor Works
Both investors and advisers tend to consider market returns in terms of averages. Averages smooth out volatility and show how investments perform over time.
Investors usually are advised to ignore market volatility and focus on long-term returns. Generally, this is a good strategy, because moving in and out of stocks based on short-term ups and downs in the market can put your money at more risk. That’s because most investors trying to time the market end up missing gains when the market recovers.
However, individual investments and portfolios don’t move up and down based on market averages. They rise and fall based on daily market movements. That’s where this type of risk comes in. An investment portfolio must have time to benefit from long-term gains, especially in retirement. Research shows that when investment losses take place early in retirement, it can be difficult for a retiree’s portfolio to recover.
Sequence of Returns Example
Let’s return to the example of the market drop in 2008 to illustrate how the order in which investment returns occur impacts an actual investment portfolio. Consider the example of a retired couple with $1 million in investments, with 60% of that invested in the stock market and 40% in the bond market. We’ll use the S&P 500 for the stock market portion and the S&P U.S. Aggregate Bond Index as a proxy for the bond market. When the market falls early in retirement, this couple takes a nearly $200,000 hit right off the bat.
| Header Cell - Column 0 | Jan. 1, 2008 balance | 2008 return | Dec. 31, 2008 |
|---|---|---|---|
| 60% stock market | $600,000 | -37.00% | $378,000 |
| 40% bond market | $400,000 | 5.70% | $422,800 |
| Total | $1 million | Row 2 - Cell 2 | $800,800 |
| 4% yearly withdrawal | Row 3 - Cell 1 | Row 3 - Cell 2 | $32,032 |
Let’s contrast Table 1 with a scenario in which favorable returns, Table 2, occurred instead. These favorable returns work in a retiree’s favor and manifest themselves in a situation where the stock market climbed in the first year of retirement. This table shows how the portfolio would have performed if the stock market portion rose and the bond market portion declined by the same percentages as in the earlier example.
| Header Cell - Column 0 | Initial balance | Return | End balance |
|---|---|---|---|
| 60% stock market | $600,000 | 37.00% | $822,000 |
| 40% bond market | $400,000 | -5.70% | $377,200 |
| Total | $1 million | Row 2 - Cell 2 | $1,199,200 |
| 4% yearly withdrawal | Row 3 - Cell 1 | Row 3 - Cell 2 | $47,968 |
The difference between the portfolios is nearly $400,000, or 40%. The impact on a 4% withdrawal rate from that portfolio, used for retirement income spending, is startling. The couple in the first example has $32,032 to spend, while the couple in the second example has $47,968 to spend, a nearly $16,000 difference.
Timing Your Retirement
Since there aren’t any crystal balls available, people can’t time the market and retire at just the right moment. However, there are some strategies financial advisers experienced with retirement income planning can implement to mitigate sequence of returns risks.
1. Planning for market downturns
Investors and retirement savers need to understand market dynamics. Anyone on the brink of retirement today is in a situation where the bull market entered its ninth year on March 9, which ranks as the second-longest bull market on record.
That doesn’t mean the market is ripe for a fall, but the length of the bull market is something to keep in mind. At times like these, those close to retirement should consider re-allocating assets toward investments that can provide guaranteed income in retirement and away from those that might fall in value when the bull market eventually ends.
2. Examine your asset allocation
Asset allocation involves spreading your investment dollars across different types of investment products. Changing your asset allocation positions your portfolio for a lower level of investment risk. Consider allocating more assets in retirement toward products and investments that provide guaranteed income so you can cover your expenses and enjoy your lifestyle.
3. Diversify your portfolio
Diversifying a portfolio among various asset classes helps hedge against the risk of a falling stock or bond market. For example, moving investments into sources of guaranteed income, such as annuities*, avoids losing investment value and income should the stock or bond market fall, providing less risk and a higher level of income.
4. Fill up your buckets
Finally, many retirement income financial advisers employ a “bucket” approach that allocates specific “buckets” of savings for specific purposes. Using that approach, a certain amount of money is set aside for ongoing income, future health care expenses, emergency expenses, capital expenses (a new car, for example) and other needs. Funds tagged for ongoing income, for instance, then would be placed in an investment that would be less subject to market risk and more likely to provide an ongoing income stream.
The Final Word for People Nearing Retirement
Consider your current retirement income plan and ask yourself this: Will it hold up against the pressure of sequence of returns? Consider incorporating financial vehicles that may help reduce the risk during your retirement.
Written in collaboration with Amy Buttell.
*Guarantees, including optional benefits, are backed by the claims-paying ability of the issuer, and may contain limitations, including surrender charges, which may affect policy values.
Securities and advisory services offered through Client One Securities LLC, member FINRA/SIPC and an Investment Adviser. Sawyer Wealth Management and Client One Securities are not affiliated. Member FINRA & SIPC.
-
The Hidden Costs of Caregiving: Crisis Goes Well Beyond Financial IssuesMany caregivers are drained emotionally as well as financially, leading to depression, burnout and depleted retirement prospects. What's to be done?
-
Cash Balance Plans: An Expert Guide to the High Earner's Secret Weapon for RetirementCash balance plans offer business owners and high-income professionals a powerful way to significantly boost retirement savings and reduce taxes.
-
The Hidden Costs of Caregiving: Crisis Goes Well Beyond Financial Issues
Many caregivers are drained emotionally as well as financially, leading to depression, burnout and depleted retirement prospects. What's to be done?
-
Cash Balance Plans: An Expert Guide to the High Earner's Secret Weapon for Retirement
Cash balance plans offer business owners and high-income professionals a powerful way to significantly boost retirement savings and reduce taxes.
-
Five Things You Can Learn From Jimmy Buffett's Estate DisputeThe dispute over Jimmy Buffett's estate highlights crucial lessons for the rest of us on trust creation, including the importance of co-trustee selection, proactive communication and options for conflict resolution.
-
I'm a Financial Adviser: For True Diversification, Think Beyond the Basic Stock-Bond PortfolioAmid rising uncertainty and inflation, effective portfolio diversification needs to extend beyond just stocks and bonds to truly manage risk.
-
I'm a Retirement Psychologist: Money Won't Buy You Happiness in Your Life After WorkWhile financial security is crucial for retirement, the true 'retirement crisis' is often an emotional, psychological and social one. You need a plan beyond just money that includes purpose, structure and social connection.
-
Retiring Early? This Strategy Cuts Your Income Tax to ZeroWhen retiring early, married couples can use this little-known (and legitimate) strategy to take a six-figure income every year — tax-free.
-
Ditch the Golf Shoes: Your Retirement Needs a Side GigA side gig in retirement can help combat boredom, loneliness and the threat of inflation eroding your savings. And the earlier you start planning, the better.
-
Roth IRA Conversions in the Summer? Why Now May Be the Sweet SpotConverting now would enable you to spread a possible tax hit over more than one payment while reducing future taxes.
