By Jeffrey Costello, CFF®, and David Buckwald, CFP®
A successful retirement plan may be no match for Lady Luck. For bad luck, that is.
To see a hypothetical example of bad luck, suppose Kate Davis had been a diligent investor throughout her working years. Investing consistently in a diversified portfolio of equities, Kate built a $1 million retirement fund by 2007, a year ahead of her planned retirement. Anticipating a $40,000 (4%) withdrawal in 2008, Kate felt very comfortable about her future finances.
Then the bad luck struck. In 2008, the broad stock market dropped over 30% amid a global financial crisis. Between the market crash and her withdrawals during the year, Kate went into 2009 with only $660,000. If Kate were to withdraw another $40,000 that year, with no increase to keep up with inflation, she would be trimming her retirement fund by more than 6%, a rate that could lead to her depleting her portfolio, in time.
Out of Luck
Here, Kate was a victim of sequence of returns risk, also called sequence risk. Equity markets are volatile, and if a steep slide occurs just before or just after the start of retirement, the chance of running short of money will increase, even for the most intelligent investor.
Note that sequence risk does not apply to everyone. As mentioned, markets are volatile, so disastrous years such as 2008 are generally followed by rebounds, which in this case occurred over most of the next decade. Indeed, bad years are actually good news for younger investors, as they can “buy low” with periodic outlays while stocks remain depressed.
On the other hand, sequence risk is particularly perilous for recent retirees and near-retirees. Once the paychecks stop, there may be little cash for buying devalued stocks. Instead, retirees tend to be drawing down their retirement funds to meet spending needs.
Especially if cost-of-living increases are built into a retirement plan, portfolio drawdown can snowball as money pours out without needed growth. After a 30% decline, for example, a portfolio must grow by nearly 43%, just to return to the previous level. A retirement fund could disappear entirely before ample returns finally emerge.
Yes, it is possible to counter sequence risk by cutting spending to sync with lower asset values. That approach, though, could lead to a depressing retirement lifestyle, as costs rise for expenditures on food, medical care, and so on.
Another way to address sequence risk might be holding down planned spending at the onset of retirement, with an option to increase outlays when a strong market boosts portfolio values. This method might mean many years of doing without desired purchases or activities, however.
At our firm, we prefer to address potential sequence risk by realizing that a vicious bear market could slash equities at any time. Therefore, we plan to have clients shelter a portion of their income-producing investment holdings in low volatility assets. This gives pre-retirees and recent retirees access to needed income for up to a decade, regardless of market moves, and avoids exposure to sequence risk.
Suppose, for example, that our Kate Davis has a younger cousin Zach, who expects to retire in 2021 with $1 million of savings. Crunching the numbers with Zach, we determine he will need to tap his portfolio for $40,000 next year, to maintain his desired lifestyle. (Zach also will have Social Security benefits and some freelance work, in this exercise.)
Thus, we would advise Zach to hold $400,000 in lower volatility assets when he retires. He will have less stress about possible market movement, knowing that he can draw down those low-volatility holdings for many years, for his spending needs, while still having the opportunity for appreciation in his portfolio.
Zach would hold the remaining $600,000 in potential growth assets such as equities. Historically, well-chosen growth assets have performed well over long time periods; if this continues to be the case, Zach may see those volatile assets gain value over time, providing funds to replenish his spendable accounts as he grows older.
Part of our plan to address sequence risk is deciding which low-volatility assets to use as shelter for individual clients. Holding all of the money in federally-insured deposit accounts might produce absolute safety, but yields on such accounts are near record lows today.
Therefore, most clients prefer to use other assets for part of their sheltered funds, such as bonds, fixed rate annuities, fixed index annuities, and additional investments that may have a place in conservatively managed portfolios. Conversations with clients will determine how much they decide to hold in cash, with low risk and scant yield, and how much they might prefer to keep in assets with somewhat higher yields as well as some risk of principal.
Know Where to Hold ‘Em
Another factor to consider in developing a portfolio to address sequence risk is asset location. Holding certain types of assets in the wrong place could lead to unwanted results.
To see a possible problem, consider a client I’ll call Patricia Smith, who came to our firm in her late 60s, with $1 million in liquid assets. She held about $500,000 in equities and $500,000 in fixed income, which at first glance might appear to be well-balanced.
That said, it turned out that Patricia had all $500,000 of her equities in her traditional IRA and the $500,000 in fixed income in taxable accounts, including holdings at a brokerage firm. Why was that a concern?
Because Patricia was in her late 60s, as stated. Starting at age 72, people generally must take required minimum distributions (RMDs) from their tax-deferred retirement accounts, with any shortfall subject to a 50% penalty. (Until a recent law change, RMDs began at age 70-1/2. Although RMDs have been suspended for 2020, they probably will reappear in the future.)
With the way her portfolio was structured, Patricia would have had to sell equities within her IRA to meet her RMD. In a bear market, she’d be forced to sell some stocks at low levels: a poor strategy for long-term wealth preservation. Thus, Patricia could have been a victim of sequence risk, with her incoming holdings, if a bear market occurs in the next few years.
By carefully culling the equities within Patricia’s IRA—unloading the stocks and funds that seem to have the least upside, going forward—we have used the sales proceeds to buy cash and bonds, to hold in her IRAs. They can be tapped for future RMDs.
Meanwhile, we have used some of the cash in Patricia’s taxable accounts to restore her overall stock market allocation. In a taxable account, she can take capital losses, hold appreciated equities to leave to loved ones for a basis step-up, and execute other tax planning tactics.
Also, by holding stocks in a taxable account, Patricia will pay tax on any long-term capital gains in her equity portfolio there at favorable rates, currently no more than 20%. Any gains in her IRA would be taxed at ordinary income rates upon withdrawal, currently as high as 37%.
The bottom line is that retirees with substantial assets in taxable as well as tax-deferred accounts should consider all the ramifications when deciding which holdings should go where. At the end of the day, where you are invested is as important as how you are invested.
Opposites not Attractive
In truth, Patricia’s 50-50 asset allocation, equities to fixed income, is far from the norm. Most people who come to us are close to 100%, at one pole or another.
That is, some new clients are extremely conservative, with virtually all of their money in bank CDs, government bonds, and so on. They are not exposed to sequence risk but they have locked in low yields, which means their assets probably won’t grow to keep pace with inflation over a lengthy retirement.
Other individuals join our client list with most of their money in stocks, where long-term results generally have been superior. They have growth potential but they’re the ones most vulnerable to sequence risk, if a bear market comes out of hibernation near their retirement starting date.
For all such newcomers, our goal is to restructure their holdings to provide an acceptable balance between safe instruments and investments with growth potential. Included in those plans are substantial amounts of cash and near-cash, assets they can tap during a stock slide without depleting equities. That strategy can reduce sequence risk.
Revealing the Risk
For many people approaching or in retirement, sequence risk is an unfamiliar concept. If stocks have up years and down years but generally generate substantial long-term returns, what difference does it make when the good or bad times come?
We put the issue in perspective by asking clients to recall how they have felt during the 2000-2002 tech stock collapse as well as during the 2008 crash, when market losses dominated the news. If they were retired then, would they have liked to have had an old-fashioned pension? To have an assured income stream, month after month, regardless of how their stocks performed?
Clients grasp the value of not fretting about where their next dollars will be coming from, so they understand the reason for having some assets sheltered from market volatility. Indeed, while stocks plummeted in February and March of 2020, we didn’t receive any panicky calls from clients, even those in or near retirement—the calls we got were from clients asking what we thought about buying stocks then, when they were “on sale!”
In essence, the key to reducing sequence risk is holding a well-balanced portfolio, diversified between growth assets and those with low volatility. That means not stretching for maximum long-term returns but keeping some holdings that can provide a safety net while the remainder of your portfolio can potentially generate above-inflation returns over the long term.
About the authors: Jeffrey Costello, CFF®, and Dave Buckwald, CFP®
Jeffrey Costello, CFF®
Retirement Income Planning & Employee Benefits Specialist. As a retirement income planning and employee benefits specialist for OneTeam Financial, Jeffrey is passionate about educating clients on holistic financial planning to achieve their financial goals and independence.
Jeffrey helps both pre-retirees and retirees to optimize their hard-earned savings and to develop reliable income sources in retirement. In addition to working with individuals and families, he also assists businesses with their employee benefit offerings.
Dave Buckwald, CFP®, CLU®, ChFC®, CLTC®, is CEO and founder, at OneTeam Financial. Dave has been providing financial advice and guidance to clients for more than 30 years. He works with individuals, families and business owners to help them achieve their financial goals so they can spend more time doing what makes them happiest. His mission is to help clients preserve the wealth that’s taken a lifetime to build with specialties, including life insurance, estate planning and wealth transfer strategies.
With his leadership, OneTeam has continued to expand its team of specialists to deliver a knowledgeable and coordinated, holistic financial planning experience to its clients and community.