Sequence risk a threat to retirees

Two severe bear markets during the past decade have put a spotlight on something that was easily overlooked…

Two severe bear markets during the past decade have put a spotlight on something that was easily overlooked during the bull market runs of the 1980s and 1990s: sequence risk. It is among a growing number of concerns for advisers to address as they develop distribution strategies for clients entering retirement.

Bear markets are easier to deal with during the accumulation phase, as investors have time to wait out downturns, benefit from recoveries and use dollar-cost averaging. The last is particularly effective in down markets, as it lets investors buy more shares at lower prices and reap the rewards when values recover.

Unfortunately, some investors employ a similar strategy during the distribution phase, systematically withdrawing assets from their portfolios regardless of what's happening in the markets. To withdraw consistent sums, they have to liquidate more shares when prices are lower. This magnifies the net impact on their portfolio and leads to a permanent reduction in the base value of their retirement nest egg.

Investors may not comprehend the mathematical realities. The sequence of returns makes no difference in a static portfolio, where an investment is made in a lump sum with no additions or withdrawals. You can scramble the returns and you'll end up at the same ending balance with the same average annual return.

DIFFERENT STORY

But it's a much different story for those in the distribution phase. The order of returns significantly affects investors' average annual return — and, ultimately, the amount they can spend during retirement.

Consider this example of two investors, Rachel and Ron, who entered retirement during two different hypothetical market cycles. Both start off with $100,000 and take $5,000 in annual distributions.

In the first year of Rachel's retirement, her portfolio returns 20%. Over the next four years, returns steadily worsen, to 6%, 0%, -6% and then -20%. Her savings are depleted as a result — to $75,366 at the end of five years — but favorable market performance early on helped limit the impact.

By contrast, Ron retired as a bear market began. His investment returns were exactly the opposite of Rachel's: -20% the first year, followed by -6% 0%, 6% and 20%. Because his nest egg was depleted substantially early on, at the end of five years it was worth $66,173, almost $10,000 less than Rachel's.

It is crucial to consider strategies that can mitigate the potential damage caused by sequence risk. One approach is to incorporate “time diversification” into a retirement portfolio. This simply means “bucketing” retirement savings into different types of assets to account for the timing of withdrawals. For example:

Money for immediate needs (bucket No. 1). Dollars held in cash or cash-equivalent investments where principal is secure. This should be a sufficient amount to cover retirement expenses over the next one or two years.

Money needed in the near future (bucket No. 2). Assets that will be tapped for expenses in the subsequent two or three years can be devoted to low- or no-volatility investments, excluding stocks and even volatile segments of the bond market.

Money for growth (bucket No. 3). Most of the portfolio can still be allocated among a diversified mix of assets, including equities, to achieve growth that will allow future distributions to keep pace with inflation. Because this money will not be required to meet income needs for several years, sequence risk is significantly reduced. In strong markets, clients can choose to start distributions or make selected asset sales and move the proceeds to buckets No. 1 and No. 2. If markets are down, they can delay distributions or asset sales temporarily, as long as the first two buckets have sufficient assets.

Many investors are skeptical that equities still have a place in their retirement portfolio. Helping clients understand sequence risk and offering solutions such as time diversification can mitigate their aversion to equities and help keep them on track for a secure retirement.

Craig Brimhall is vice president of retirement wealth strategies at Ameriprise Financial Inc.