Managing Sequence of Return Risk in Retirement

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Speaker 2
00:28
In this week’s episode, Ben and I are going to take a dive into what the sequence of returns risk is for retiree and how to avoid it before we dive in. Ben. So tomorrow is game one of the NBA Finals. I have no idea when this episode is going to air, probably after the Finals or whatever, but who do you like? What are you seeing?
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Speaker 3
00:46
Yeah, for whatever reason, I’ve been on the Celtics pretty much all season. They’ve been the best team that I’ve watched. They’ve had a really easy road to the Finals. They played the Heat. Jimmy Butler was hurt. They played the Cavs. They had a bunch of injuries, and then they beat up on the Pacers with the sweep. So they’re getting healthy. They’re getting Porzingis back. I’m really impressed with what Dallas has been doing, but I think Boston’s on another level. What about you?
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Speaker 2
01:16
Yeah, I don’t know. I’m going to root for Dallas just because of this run. I mean, they’re. They’re kind of cooking right now. I like what I think it was LeBron said this week. He’s like, Kyrie is just an absolute wild card. Like, you know, guy that’s that talented could just. He could go off in, like, the win. You know, they’ll win games, and he’s playing pretty well. So I’m going to ride Dallas. Although I think Boston is probably the better team. It’s probably more likely that Boston wins. But I’m riding Dallas.
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Speaker 3
01:44
I mean, it’s really been Luca and Kyrie, and they’ve really carried Dallas this far, which has been extremely impressive. But they’re playing. I think they’re playing a different animal, but I’m excited to watch this series, for sure.
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Speaker 2
01:57
Yeah. Let’s dive into the sequence of returns risk, then.
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Speaker 3
02:03
Let’s do it. James, why don’t you give us a background on what is sequence of return risk? Why is this important for someone’s financial plan?
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Speaker 2
02:12
Yeah. So, basically, sequence of returns risk means that when your plan goes live in retirement and you’re taking money out of your accounts to live your lifestyle, create your income stream, you’re no longer working, you don’t have a paycheck coming in. Basically, the order in which your returns occur and where you pull your money from is huge for the longevity of your portfolio. Meaning if the market’s down, your first two years of retirement, for example, we’re talking high level. We’ll get into examples here. If the market’s at a negative return, your first two years of retirement and you pull money out, we want to have fail safes in place to pull assets that are pull from assets that are still positive. Not every asset is going to be at a loss, most likely.
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Speaker 2
03:01
But if you don’t and you just sell stuff at a loss your first two years, the long term effect that’s going to have on your portfolio is huge. If you have a million dollar portfolio and it goes down 20% in year one, you take $100,000 out. Now you’re down to 700,000. And let’s say it goes down another 10%, you lose 70,000, you take another 100,000 out. To get back up to that million is going to be pretty wild. Where on the flip side, if you have a million dollars, it goes up 20%. Now you have 1.2 million, and you take that 100,000 out, you’re in the pot. I mean, that’s like a $500,000 swing right there. So that’s a general overview, and I think why this is really important, a couple of reasons. Number one, obviously, like retirement could be 20 or 30 years.
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Speaker 2
03:48
So if you derail your plan in year one, you could be in trouble. I think another reason, longevity now is a real thing with technology and advancing medicine. I just read the statistic earlier, which I thought this was fascinating. The United nations estimates that centenarians, how you say, people that live to 100, there will be 3.7 million people living to age 100 by 2015. I think the number right now, people living to age 100 is like 500,000. So that right there, we have no idea how long people are going to live. Clearly, they’re living longer. And so we have to make these assets last for as long as we possibly can. But if you mess that up in day one and you’re healthy, which most people want to be, and you live longer, you could run out of money.
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Speaker 2
04:34
So we want to avoid that. And this is the biggest way to do that.
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Speaker 3
04:36
Yeah, I think the way that this is not underrepresented in financial plans, but maybe under thought about is when people do financial models or they model out their retirement, they think, hey, I’m going to get a 6% return cumulative throughout the 20 years, I’m going to take 4%. So my portfolio is growing 6% and I’m only taking out 4%. Man, there’s a 2% gap that’s just growing forever. I’m going to be fine, but it’s not that simple. It’s not that easy. Your portfolio is not growing at a flat 6% every year. There’s going to be years where it’s down ten, up 25, down 20. Like, it may average 6% over the course of your retirement, but it’s not going to be a flat 6% every year. And you’re not going to just spend a flat 4% every year.
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Speaker 3
05:22
There are going to be years where there’s more spending, there’s going to be years where there’s less. Just thinking about this from, like, an actual example, let’s assume there’s a three year period, right when you start retirement. The first year of retirement, your portfolio goes down 20%. The second year, you’re up 20%, and the third year, you’re up 20%. So, again, negative 2020, that three year cumulative return was 6.6%. So, again, we’re right in that model where maybe you feel comfortable, hey, I’m at. I’m earning 6.6%. It’s no big deal. But if you take out a 5% withdrawal rate on a portfolio that’s down 20% in year one, you’re severely limiting the sustainability of your plan long term. Think about this for an example. If you have a $1 million portfolio, it’s down 20%. Now you’re at 800,000.
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Speaker 3
06:14
Then from that $800,000 balance, you take a 5% withdrawal rate. Now we’re down to 760. So we felt really good about having a million dollars saved. And after one year where we took a distribution when the market was down, we’re at 760. Next year, market goes up 20%. But we’re not back to our million because we’ve already locked in our loss. A 20% return on our $760,000 balance just gets us back to 912. So there’s almost a $100,000 swing, even though it feels like we should be back to even. But we’re down 100 because we took that distribution when the market was down and we didn’t have anywhere else to turn to, because, again, we’re retired. We need the money.
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Speaker 3
06:57
We have the money, but we need to make sure that we have the right buckets in place where we could be pulling money from even when the market’s down. So that’s just one example where we don’t know what the market’s going to do when we are retired. If we’re planning for this, there needs to be some foresight in mind.
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Speaker 2
07:14
Yeah, totally. Basically, I think that the big takeaway, and we’ll get into examples here, is you have to have a plan on how you’re distributing your assets, what assets you’re going to pull from, depending on what the market’s doing. And if you don’t, you could really derail your plan in retirement. So Ben, why don’t you give us, you kind of went into this a little bit, but why don’t you give us an overview of. We show this page to most client meetings, just the sequence of return risk, this PDF that we generally walk through.
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Speaker 3
07:46
Yeah, and we’ll be able to superimpose this on the screen here. So you’re following along, but this has, this shows basically three investors that invested $1 million each at the age of 40. They didn’t touch it. And then it grew 7% over 25 years. So they all get to 65. This is Misses Jones, Mister Smith, and Mister Brown. Again, they put a million dollars in at 40. It grew 7% over 25 years. At age 65, they all had the same portfolio value, although they experienced different valuations along the way. So misses Jones, for example, the first year, up 22%, up 15%, up 12%, and then you see the returns year over year to eventually get to the average return of 7%. Mister Smith again went down 7% in the first year, down 4%, so on and so forth, up until 7%.
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Speaker 3
08:40
You’ll notice that Mister Smith and misses Jones’s returns are just flipped. So the return that misses Jones got at her age of 41 is the same return that Mister Smith got at his age of 65. So those columns are just flipped. And Mister Brown just got a flat 7% return year over year. Point is, they all got to the exact same point, five point four million at the end of the 20 year period. So we go to the next slide. And now this is where sequence of returns risk actually comes into play. All three of them are making withdrawals of $60,000, adjusted annually for inflation, from their age of 66 to age 90. And you see, we have the same kind of scenario here where misses Doe is withdrawing money, where the market’s up 22% in the first year, 15%, 12%.
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Speaker 3
09:36
Mister White has the same returns, but flipped. And then Mister Rush has 7% returns throughout age 66 to age 90. So misses Doe, because she’s withdrawing that $60,000 the first three years where she’s up 22, she’s up 15, she’s up twelve, she’s able to end her at age 90 with still over a million dollars remaining in the portfolio. So she’s fine. She was able to take those distributions those first three years when the market was up and she didn’t run into any issues. Whereas Mister White, again, same exact returns as misses Doe, but just flipped because subject to some distributions in the first couple of years when the market was down, he runs out of money at age 89. Even though they all got to the same point with the returns, they all started with 5.4 million.
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Speaker 3
10:30
But again, it totally depends on what is going on in the market when you’re actually taking the distribution. So makes a huge impact. Again, they didn’t have anywhere else to turn to. They needed the 60,000. But just because misses Doe was able to do it the first three years when the market was up, whereas Mister White had nowhere else to turn to, Mister White ran out of money at age 89 and misses Doe still had a million dollars left over at age 90.
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Speaker 2
10:55
We’ve identified this can be a huge problem. Let’s talk about what we do to solve for that problem. Number one, just having a properly diversified portfolio. So if you’re overly concentrated in one single or two or three asset classes, you’re going to see much more volatility in your portfolio versus if you’re properly diverse, there may be years where us equities are getting crushed and maybe some international, totally making this up international developed is positive, or what would be more likely is all equities are down and fixed income is positive. So making sure you’re properly diversified, that’s going to eliminate some of the oscillation of the portfolio.
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Speaker 3
11:38
Just right on that note, because that’s such a good point. If you retired in January 1 of 2020, the next three years were pretty horrible for us equities. So if you had international exposure, maybe some of those positions were up, and again, you needed that $60,000 in that example, from the sequence of returns risk, maybe you’re pulling it from the international funds that are up and you’re letting the funds in, the us equities or the S and P 500 come back.
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Speaker 2
12:03
Yeah, totally. And then another strategy we use, have a seven year backup as you’re getting ready to enter retirement. So if you need round numbers, if you need $100,000 a year in portfolio withdraws, we’re going to want that times seven in something safe. So 700,000 so you have a $3 million portfolio. 700,000 in cash. Fixed income. Cash value inside of a life insurance contract. That’s what about less than a 70 30? 70 30 would be about a third ish. Somewhere around a 70 30 allocation. And how we want that seven year structure. We’re going to want one to two years in cash. You may just be in a money market, maybe in treasury, something that we know you’re going to spend. Then we want.
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Speaker 2
12:53
If we have enough time to get there or we’re working with a client for long enough time, we want two to three years of that in cash value instead of a life insurance contract and then fill the remaining with fixed income. And that’s going to basically there’s never been an eight year period in the history of having a properly diversified portfolio that everything’s been down. So what that’s going to do, we have two years. We know we can spend the cash value inside life insurance for another two to three years. That has zero correlation to the stock market. And then we have fixed income. But we know fixed income as we’ve seen the last couple of years can be down with depending on interest rates. So that’s not always foolproof.
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Speaker 2
13:29
But if we have the cash value of the cash in different buckets to pull from that generally can avoid this. And then the other thing. This is called a bucket strategy. So basically timing up when you want. Similar to that seven year backup. But basically anything in the short term we want safe. Midterm we’d want fairly safe. And then long term we can invest in long term equities knowing that let’s let this grow. And no, we’re not going touch this for ten plus years or never touch it. And it gets passed on legacy. Any other ways to. Any other thoughts or how else can we avoid this?
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Speaker 3
14:05
Yeah. I would say one other thing to add would be just consider if the market is down. Consider Roth conversions during down markets. Let’s say you have a traditional IRA balance. Market goes down. Balance drops. If you wanted to convert a portion of this to your Roth, you’re paying tax on a lower balance. Any of the growth and recovery that occurs is now in a Roth. So that’s completely tax free. It also eventually limits your taxable income and RMD’s in the future. The more money you have in Roth. So market is down. It’s a good time to get more money into generally a good time to get more money into your Roth account. For those reasons.
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Speaker 2
14:39
A really good point. Required minimum distributions can be one of the main reasons why you’re forced to take money out if the market’s down. Hidden age government says you have to start pulling money out. They don’t care what’s going on in the stock market. Roth accounts don’t have any RMD’s. So the more money you get into a Roth earlier on, that’ll help avoid the sequence of return risk as well. It’s a good point. I’m glad you brought that up.
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Speaker 3
15:03
Yeah, because again, you don’t have to take money out if you don’t want to. So those years that we referenced in that example, maybe again, back to that, mister White, negative seven, negative four. The first years of retirement. Well, if you have more money in Roth, you can take money from other places. You don’t have to take from the Roth account. Huge benefit.
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Speaker 2
15:22
Yeah. And then I would say just start prepping for this two to three years before you think you’re going to retire. Avoid the blanket advice of you’re getting to retirement, you should have a 60 40 portfolio. It’s probably not accurate for your situation. So get specific on your financial plan, what makes sense for your situation, and start scaling back your equity exposure two to three years before you retire to start planning for this.
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Speaker 3
15:47
Absolutely.
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Speaker 2
15:49
Anything else?
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Speaker 3
15:50
No, I think that makes complete sense. But I would say sequence of return risk, this is something that is coming down the road. So it’s just something that you plan for in your working years, and then you have the plan in place by the time your retirement is live. So if you have any questions about how your assets are allocated, what your strategy is for addressing sequence of return risk, feel free to reach out to a tax or financial advisor to get a personalized financial plan in place.
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Speaker 1
16:17
Thanks for tuning in to our podcast. Hopefully you found this helpful. Really hope this is as beneficial and impactful to as many people across the nation as possible. So hit the follow button, make sure to rate the podcast, and please share with any friends or family members that would also find this beneficial. Thank you very.
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