Sequence of returns risk is often overlooked as a significant risk to a retirement plan even though it is among the largest risks that older investors face, Morgan Stanley Wealth Management points out in a new report, “Retirement Income and Sequence of Returns Risk.”
Sequence of returns risk refers to the possibility that low returns early in an investor’s retirement can deplete his or her portfolio just as they start spending their nest egg. When this happens, the portfolio takes a hit from declining asset value, especially if the market is in a downturn, as well as from withdrawals.
Advisors should all be aware of this issue and factor it into the retirement plans of their clients, who often aren’t even aware of what sequence of returns risk is.
Fortunately, however, there are several ways to mitigate the problem, according to the Morgan Stanley report.
Here are 10 top takeaways of interest to advisors and investors from the report:
1. It is crucial to have a well-designed and faithfully implemented retirement income strategy.
A diversified portfolio, regular saving, careful planning and not overtrading are the “key pillars” of a successful strategy, according to the report.
Faithfully sticking to that plan is crucial because these best practices “mitigate several important risks to a retirement plan, according to Morgan Stanley.
2. Even with a good plan, advisors and investors still must address sequence of returns risk.
Even investors with a strong retirement strategy who stick faithfully to that plan could be affected by sequence of returns risk, the report says, noting it has “often been neglected as a source of risk” in retirement and provides “considerable potential to upset the applecart.”
3. Advisors have all too often not done a good job helping investors minimize sequence of returns risk.
Although diversification, planning and monitoring are “accepted tenets of industry advice, the industry historically hasn’t done as good a job helping investors minimize sequence of returns risk,” according to Morgan Stanley.
4. A good example of that mistake is the way in which target date funds handle strategy in the retirement phase.
“One of the better examples of that shortcoming is the way that so-called target date funds, which are products asset managers create to help investors accumulate and distribute retirement savings, handle strategy in the retirement phase,” according to the report.
Target date funds are multi-asset class products whose asset allocation changes during an investor’s lifetime, mainly by reducing the allocation to equities as the investor ages, a feature known as its asset allocation glidepath, as Morgan Stanley explains.
“Although different managers of such funds have approached asset allocation differently, many of the most popular fund series recommend a declining equity allocation during retirement,” the report says.
That, however, “can actually worsen sequence of returns risk using the recent experience of the unfavorable sequence of returns suffered by investors who retired in the year 2000, just before a difficult decade for markets that included the global financial crisis,” Morgan Stanley notes.
5. Investors will be facing this issue at an especially bad time.
Investors who are left open to sequence of returns risk are left wide open to facing “financial duress at a time in their life when duress can be very unforgiving to manage,” according to Morgan Stanley.
6. Buying more stocks isn’t the only option.
There are fortunately “ways to mitigate sequence of returns risk that gel better with investor preferences than recommending higher and higher allocations to equities as retirees age,” the report says.