How sequence of returns risk can impact when to retire

One of the most important financial decisions you make in life is choosing when to retire. You want to enter this stage of life feeling confident that you’re financially prepared for the future.

Even if you have control over choosing when to retire, market volatility and other financial factors can have a significant impact on your income stream as you approach or enter retirement. One of the primary risks retirees must consider is sequence of returns risk.

The unique financial challenges facing retirees

Managing assets in retirement can be a far more challenging task than when your focus is on asset accumulation, as it is during your working years. As retirement approaches, or in retirement, you no longer have the luxury of time to overcome temporary market fluctuations.

A variety of factors can present financial difficulties for retirees. They include:

• Markets that fluctuate in value. Investors must accept that periodic market downturns will occur. “Market volatility is a real risk for retired investors,” says Shannon Baustian, Private Wealth Advisor with U.S. Bank Private Wealth Management. “You should be careful about putting money to work in a passive fashion and simply hoping that you’re on the right side of the markets.”
• Retirements that are lasting 20-to-30 years or longer. “You need to have a big enough nest egg to meet income needs over an extended period of time, which may necessitate working longer to accumulate that nest egg,” says Tom Hainlin, national investment strategist at U.S. Bank Wealth Management.
• Taxes on retirement income. Most or all distributions from employer retirement plans and traditional IRAs are subject to tax at ordinary income tax rates. “Limiting the tax hit on distributions is important to preserve principal to last through the course of retirement,” says Baustian.

These factors underline why investors can’t simply rely on strategies that might have been effective during their working years.

Sequence of returns risk – timing is everything

Sequence of returns risk applies specifically to retirement income planning. The concept is simple – it’s the risk of negative market returns occurring late in your working years and/or early in retirement. At this stage of your investment life, market downturns can have a much more significant impact on your portfolio and your lifetime income strategy.

“You always want to be careful about liquidating assets in down markets to meet income needs,” says Baustian. “This is where sequence of returns risk comes into play.”

Consider this hypothetical example of two retired investors, both of whom invested $1,000,000 as retirement began and planned to withdraw $45,000 per year, adjusted upward by 3% every year to account for inflation.

Over the course of retirement, their portfolios will generate comparable annual returns, but following a different year-to-year return pattern. For example, the first investor benefits from three initial years of positive returns (25% in year 1, 10% in year 2, 5% in year 3) before experiencing a negative return in the fourth year (-15%). The second investor experiences a more difficult investment environment in the initial year of retirement (-15%), followed by gains in the three subsequent years (5%, 10% and 25% respectively).

For both investors, the same pattern of returns and income distributions continues throughout retirement.

The first investor benefits by earning positive returns in the initial years of retirement. The portfolio experiences growth as a result, even as income is generated by liquidating assets. This strong start to retirement allows the investor’s nest egg to generate the desired amount of income for 40 years.

The second investor had the unfortunate timing of retiring in a year when the markets were down. Just a single year of negative returns, occurring at the outset of retirement, meant the portfolio lost significant value in the first year. Because assets are being sold into a down market, the portfolio can’t recover as it could during the accumulation period, when investments are allowed to continue to grow and have time to overcome the impact of a negative market turn. This caused significant damage to the investor’s long-term income strategy, with money running out after just 25 years.

How likely is it that your retirement date could coincide with a down market year? Since 2000, markets experienced negative results 25% of the time.

Because of the unpredictable nature of capital markets, says Hainlin, “it’s important to develop a strategy that avoids drawing down principal at the beginning of retirement. Once spent, those assets can no longer generate the growth necessary to last through retirement.”

Balance sequence of returns risk with a retirement bucket strategy

“Retirement is a long runway, and you need growth in your assets,” says Baustian. One income strategy to consider is to set aside a portion of your assets to meet your needs through various phases of your retirement. “We often look at ways to separate retirement assets into three ‘buckets,’” says Baustian.

These include:

• Liquidity. Carve out assets to meet income needs for the first 3-5 years of retirement. This money should be kept in more liquid assets with minimal exposure to market fluctuations, including cash equivalent investments and short-term bonds.
• Lifestyle. A portion of dollars to meet needs for the next 10 years can be invested more aggressively. “Use a disciplined asset allocation strategy with these investments so they can continue to grow,” says Baustian. “Some of the money is regularly shifted to replenish the ‘liquidity’ bucket.”
• Legacy. “The dollars in this bucket can be invested with future generations or key charitable causes in mind,” says Baustian. “There may be more flexibility to invest these dollars in assets outside of traditional stocks and bonds.” This is money that can be held until the latter part of your life, again invested with the long-term in mind.

The bucket strategy is an effective approach to avoid selling assets that can fluctuate in value and are subject to loss in a down market.

Build a portfolio for long-term growth

A diversified portfolio that better weathers market volatility begins with owning an appropriate mix of investments aligned with your risk tolerance level.

Having an equity component in your portfolio is important, says Rob Haworth, senior investment strategy director at U.S. Bank Wealth Management. “The growth potential of equities is critical to help manage longevity risk and inflation risk,” he notes.

Many retirees also look to add bonds to a portfolio to generate income. “It’s important to recognize that even though bonds generate more attractive yields in today’s elevated interest rate environment compared to years past, inflation is higher too,” says Haworth. “Investors can’t rely on a ‘set it and forget it’ strategy. It’s important to keep monitoring the environment and manage risk in your portfolio.”

Hainlin recommends that investors look for ways to generate income that goes beyond traditional bonds and dividend-paying stocks. “Given the current high-interest rate environment, it can be beneficial to diversify into investments that have historically performed well in these circumstances.”

Hainlin notes infrastructure-related investments can have the potential to generate competitive and diversified income relative to traditional stocks and bonds. “Select sectors and industries including utilities, transportation and pipeline companies are examples of targeted investments with attractive prospects that can provide differentiated income for retired investors,” he notes.

Think about taxes

Too many retirees fail to consider that taxes can be a significant expense during retirement. You may be required to take larger distributions than you planned because withdrawals from 401(k)s and traditional IRAs are subject to tax at ordinary income tax rates.

“As you plan for your retirement, it can be a good idea to direct at least some of your savings into Roth IRAs or Roth 401(k)s,” says Baustian. If holding period requirements are met, distributions from Roth accounts are tax free. In addition, required minimum distribution rules that apply to traditional IRAs and 401(k)s don’t apply to Roth IRAs. “This can help preserve capital so your retirement assets last longer,” she adds.

Be prepared to execute your goals

If you set a retirement date, you don’t want to be forced to change it due to a negative turn in the markets. “You should consider starting to position your assets for retirement about 2-3 years before you reach that date,” says Baustian. “It can even be initiated five years out. You’ll want to evaluate all the potential sources of income available to you.”

Among the issues to consider in the years leading up to retirement are when to begin claiming Social Security, contributions from company pensions, and if there is any deferred compensation that will be available to fund retirement cash flow needs.

Along with assessing potential income sources that can supplement what you need to generate from your own savings, Hainlin says there are other issues to consider. “Understand what your investment portfolio is exposed to that could put your long-term financial security at risk in the event markets move in an unanticipated direction. Interest rates, inflation, energy prices, and government policies are examples of factors that can influence the future path of investment returns. It can be beneficial to broaden your investments and sources of cash flow.”

Hainlin adds that it’s important for those entering or already in retirement to maintain a degree of flexibility. “Of course, increased life expectancy is a welcome social development, but it creates significant challenges in terms of the increasing costs of retirement over time,” says Hainlin. “Add to that the potential for unpredictable markets, and retirees need to be willing to make adjustments over time to maintain their long-term financial security.”

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