Why Gauging Sequence of Returns Risk Is Vital in This Market

After more than 10 years of a rising bull market, it’s been easy for advisors and clients alike to fall prey to recency bias — the tendency to assume that markets and the economy will keep chugging along at the same rate. Recent stock market volatility fueled by coronavirus concerns provides a good reminder that things can change quickly. When change comes, your clients who are living in the years just before or after retiring will stand to lose the most.

“Risk management is most critical for investors near, at, or just past retirement, especially in this market environment,” says Clark Richard of Vineyard Global Advisors in Denver. “It’s a little like Mt. Everest, where the greatest risk is in the time period just before and after a climber summits. Likewise, in retirement planning, you need portfolios designed to avoid slipping and falling around those pivotal years.”

So why do the years immediately before and after retirement have such a disproportionate impact on future wealth? The answer has to do with sequence of returns risk, which refers to the possibility that low returns in early retirement deplete a client’s portfolio just when they start spending their nest egg. In this situation, the portfolio takes a hit not only from declining asset values, but also from withdrawals. That one-two punch erodes the client’s capital base, leaving fewer shares to participate in an eventual market rebound. Retirement expert David Littell warns that “Negative returns in the first few years of retirement can add significantly to the possibility of portfolio ruin.”

Why the Risk Is Higher Today

The International Monetary Fund expects U.S. GDP growth of just 2% in 2020, and global growth of 3.3% — a significant decline from last year. An escalation in geopolitical risk could easily drive those projections lower. In addition, the prospect of below-normal growth in an environment of high stock valuations and low interest rates opens the possibility of an eventual market correction, underscoring the need to prepare client portfolios now.

Adjusting the Glidepath Toward Retirement

To reduce sequence risk, a client’s retirement portfolio should be gradually repositioned toward a protection of principal mandate in the five to 10 years before they plan on retiring. This means shifting assets toward lower-volatility funds, conservative fixed income investments and/or annuities, and managing downside risk through alternative investments that include hedging strategies. The goal is a portfolio well insulated from market shocks.

Using Flexibility to Reduce Risk

Another approach to addressing sequence risk is to choose a flexible withdrawal strategy. A typical retirement plan involves withdrawing a fixed percentage of the original portfolio value to provide steady income, but this strategy leaves the client exposed to sequence risk. If the client instead has the flexibility to withdraw amounts that are based on a percentage of the current portfolio value, sequence risk can be eliminated. The downside to this approach is that the size of withdrawals will vary and may not be enough to meet the client’s spending needs.

A compromise between these two approaches would be to start retirement income with a fixed percentage of the initial portfolio value, but then reduce withdrawal amounts during times of market decline. Home equity lines of credit, reverse mortgages and bond income laddering can also be utilized to avoid having to sell securities in a down market.

Though it’s a little-known concept among investors, sequence of returns risk poses one of the greatest threats to a happy retirement. Your ability to protect clients from this threat will be one of the best ways to demonstrate your worth as their trusted advisor.