By Robert Klein, CPA
So here you are, crossing the threshold from earning a living to entering retirement. You worked hard for many years. You accumulated a sizeable, diversified investment portfolio. You purchased deferred income annuities to provide you with sustainable lifetime income. You hedged your bet with life insurance and long-term care insurance. Your will and other estate planning documents have been updated to reflect your current financial situation and goals. Everything’s in place for a financially successful retirement – or so you think.
Sequence of Returns Risk
What could possibly go wrong? Flashback to October 2007, to March 2009. After doubling in value from 7,200 to 14,200 in the five-year period beginning October 10, 2002 through October 11, 2007, the Dow Jones Industrial Average (DJIA) plummeted 7,700 points, or 54%, in just 17 months to a low of 6,500 on March 6, 2009.
Welcome to sequence of returns risk. They say there’s no greater teacher than first-hand experience. If you retired during those tumultuous 17 months and weren’t familiar with this dreaded investment risk, you were quickly immersed.
Sequence of returns risk is unique to the decumulation, or distribution, stage of retirement. The order of investment returns during this stage has an impact on how long a portfolio will last, especially if a fixed amount is being withdrawn. Negative returns in the first few years of retirement, if not protected, can significantly increase the possibility of portfolio depletion.
This article is particularly timely given the fact that the DJIA, which was at 35,600 when it was written, or about 1,000 points less than its November 8th record high of 36,565, is up over 29,000 points, or 448%, from its low of 6,500 on March 6, 2009. This translates to an average annualized return of 35%. Furthermore, there have been only two small down years since 2008: 2.2% in 2015 and 5.6% in 2018.
Three Sequence of Returns Risk Hypothetical Scenarios
Let’s illustrate sequence of returns risk with an example using three hypothetical scenarios, each of which includes the following five assumptions:
- Retirement age: 65
- Life expectancy: age 90
- Initial portfolio value: $1 million
- Annual withdrawals: 5% of the initial portfolio value, or $50,000, increasing by 3% each year
- Average rate of return: 7%
Please keep in mind that none of the scenarios considers the investment account type, i.e., non-retirement, Roth, or taxable retirement, nor potential federal and state income tax liability associated with taxable investment income, realized gains, and distributions from the account.
Scenario #1 – 7% Return Each Year
Although a scenario with the same rate of return each year throughout retirement never occurs in real life, it’s often used for illustration purposes. After taking withdrawals of $50,000 in the first year of retirement that more than double to $105,000 in the final year, the portfolio in Scenario #1 remains intact, decreasing from a value of $1 million at age 65 to $924,000 at age 90.
Scenario #2 – Good Early Years
The positive returns during the first 12 years, most of which are double-digit, enable the portfolio in Scenario #2 to increase in value from $1 million to almost $3 million at age 87 before three consecutive negative years reduce it to $1.8 million at age 90. This is double the value of $924,000 in Scenario #1 despite the fact that the average rate of return during the same period is identical, i.e., 7%.
Scenario #3 – Bad Early Years
Scenario #3 reverses the order of investment returns in Scenario #2, with negative returns of 18%, 12%, and 3% in the first three years, respectively. This reduces the portfolio value by $430,000, or 43%, going from $1 million to $570,000 in just three years at age 67. Despite the fact that the investment return in 12 of the next 14 years is positive and the average return from age 65 to 81 is a respectable 5%, the portfolio is depleted at age 81. Once again, the average rate of return is 7%.
Potential Solution – Maintain Withdrawals of $50,000 in All Years
In hindsight, the longevity of the investment portfolio in Scenario #3 could have been extended, and depletion avoided, had withdrawals not increased by 3% each year and simply remained at $50,000 for the duration of retirement. This is illustrated in Scenario #4 – Bad Early Years with Withdrawals of $50,000 Each Year.
The downside of Scenario #4 is the loss of purchasing power due to inflation. Assuming average annual inflation of 3%, purchasing power of the age 65 withdrawal of $50,000 is reduced by $27,000, or 54%, to $23,000 at age 90.
Scenario #4 is far from a perfect solution in real life. Assuming that it’s necessary to increase annual withdrawals by 3% each year to maintain the individual’s lifestyle, other sources of income would be required to support her financial needs. This might necessitate the sale of her house, assuming she is a homeowner, and associated downsizing.
Not to mention the fact that portfolio depletion could still occur if the individual lives past age 90. This is more likely if investment returns are unfavorable in one or more of those years or if she experiences an uninsured or underinsured long-term care event.
HECM Reverse Mortgage – Insurance for Sequence of Returns Risk
A proactive planning solution that can be used strategically by homeowners beginning at age 62 to insure against sequence of returns risk is a home equity conversion mortgage, otherwise known as a HECM reverse mortgage. I recommend that you read Not Your Father’s Reverse Mortgage to familiarize yourself with HECMs and 5 Key Financial Metrics When Evaluating a HECM Reverse Mortgage to learn about an objective process for analyzing a HECM in any situation.
While there are several potential strategic uses of a HECM, one of the most, if not the most, important is to insure against sequence of returns risk. This is due to the fact that sequence of returns risk, by definition, is applicable to the first few years of retirement. The risk of portfolio depletion, if not protected, can increase significantly in the event that negative returns are experienced during this critical period.
How a HECM Reverse Mortgage Can Insure Against Sequence of Returns Risk
The best way to illustrate how a HECM reverse mortgage can insure against sequence of returns risk is with an example. In addition to the five assumptions used in Scenarios #1, #2, and #3, Scenario #5 – Bad Early Years with HECM Mortgage includes the following 13 assumptions:
- Apply for HECM at age 62.
- No mortgage when applying for HECM mortgage.
- Appraised home value of $1 million with assumed annual appreciation of 4%.
- HECM mortgage of 48.64% of the maximum 2021 FHA claim, or insurable, amount of $822,375, or $400,000, is approved.
- Initial mortgage insurance premium of 2% of $822,375, or $16,448.
- Initial loan amount is $25,000, which is equal to the total closing costs, including mortgage insurance premium of $16,448, origination fee of $6,000, and other closing costs totaling $2,552.
- HECM mortgage variable interest rate of 3.5% with a ceiling of 8.5%.
- Interest rate of 3.5% remains unchanged for the life of the loan.
- Annual mortgage insurance premium of 0.5% of the outstanding balance.
- No payments made on the HECM mortgage.
- Initial credit line of $375,000 (approved mortgage of $400,000 less initial loan amount of $25,000).
- Credit line variable interest rate of 3.5% with a ceiling of 8.5%.
- 100% of all withdrawals are taken from the credit line in years in which the investment account return is negative.
Per Scenario #5, withdrawals totaling $154,545 are taken from the HECM credit line instead of from the investment account from age 65 through age 67 when returns are -18%, -12%, and -3%, respectively. Withdrawals of $61,494 and $73,427 are also taken from the HECM credit line at age 72 and 78, respectively, when returns are -2% and -6%. Withdrawals from the HECM credit line total $289,465.
The strategy of taking tax-free withdrawals from the HECM credit line instead of the investment account in negative years results in the preservation of the investment account for the life of the plan. The effectiveness of this strategy in this scenario is supported by the following additional facts:
- The strategic withdrawals from the HECM credit line totaling $289,000 during the five negative return years, including $155,000 in the first three years, enabled the investment account to sustain itself for the duration of the plan.
- Whereas 100% of the HECM credit line withdrawals totaling $289,000 were tax-free, the investment account withdrawals during the same period in the non-HECM plan were fully taxable as ordinary income assuming a non-Roth retirement investment account and were potentially taxable as capital gains in a non-retirement account.
- The HECM credit line resulted in withdrawals from the investment account and credit line totaling $1.927 million ($1.638 million from the investment account plus $289,000 from the HECM credit line), or $845,000 more than the total withdrawals of $1.082 million in the non-HECM plan in Scenario #3.
- The investment account value in the HECM plan was $586,000 when the non-HECM investment account was depleted at age 81.
- The investment account value in the HECM plan was $110,000 at age 90.
- Despite the fact that withdrawals from the HECM credit line totaled $289,000, the credit line, which had a balance of $375,000 at age 62, increased to $419,000 at age 90.
- The combined balance of the investment account of $110,000 and HECM credit line of $419,000 resulted in total liquidity of $529,000 at age 90.
Cost of HECM Mortgage
The foregoing benefits associated with the HECM plan did not occur without cost. Obtaining insurance against sequence of returns risk and associated depletion of the investment portfolio came at a cost of $742,000, which was the amount of the HECM mortgage balance at age 90.
The HECM plan cost of $742,000 was well worth it when you consider the fact that the investment portfolio was intact at age 90 versus depleted at age 81 in Scenario #3. Four other factors supporting the HECM strategy are as follows:
- Additional withdrawals of $845,000, $289,000 of which was tax-free.
- Liquidity of $529,000 at age 90.
- $419,000 of liquidity was in the HECM credit line which could have been used strategically for other purposes, including paying for long-term care needs.
- Appreciation of the house of $2.119 million (value of $3.119 million at age 90 less $1 million at age 65) exceeds the mortgage balance of $742,000 by $1.377 million.
Two essential keys to this successful outcome include the fact that the HECM mortgage was obtained at age 62, the first year of eligibility, and there was no existing mortgage balance. This accomplished two things: (a) maximization of the HECM credit line and (b) minimization of the HECM mortgage balance.
Negative returns in the first few years of retirement, if not protected from sequence of returns risk, can significantly increase the possibility of premature portfolio depletion. A HECM mortgage, with its accompanying credit line, provides tax-free liquidity during this critical period to insure against this risk in lieu of taking potentially taxable distributions from an investment account that’s declining in value.
The proposed strategy enables you to ride out the storm whenever there are downturns in the market. It protects you from the temptation to sell when the market is on its way down and attempting to time the market when buying back in, both of which are generally losing propositions. All of this translates to peace of mind during the most critical stage of retirement, i.e., the first few years, that can last for the duration of retirement with proper planning.
About the author: Robert Klein
Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. The firm’s motto is Planning, Managing, and Protecting Your Retirement Income™. Bob is the creator of FINANCIALLY InKLEIN’d™, a YouTube channel featuring tax-sensitive, innovative strategies for optimizing retirement income. Bob is also the writer and publisher of Retirement Income Visions™, a blog featuring innovative strategies for creating and optimizing retirement income that Bob began in 2009.
Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies, including fixed income annuities, Roth IRA conversions, HECM reverse mortgages, and charitable remainder trusts, to optimize the projected longevity of his clients’ after-tax retirement income and assets. Bob does this as an independent financial advisor using customized holistic planning solutions determined by each client’s financial needs.