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Jeffrey Levine: 7 Things to Know About Sequence of Returns Risk

By John Manganaro

Analysis October 20, 2022 at 03:20 PM Share & Print

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As chief planning officer at Buckingham Strategic Wealth, Jeffrey Levine serves as a technical resource for advisors and the firm’s primary thought leader regarding evidence-based planning concepts and strategies.

Levine’s work at Buckingham gives him the ability to train and educate hundreds of advisors and support them in their pursuit of growth and client service goals. On Wednesday, Levine hosted a webinar summarizing some of his recent experiences and digging into a topic that he says all financial advisors must contend with in 2022: sequence of returns risk.

As Levine recounts, the current moment in the equity and bond markets is causing significant strife among retirement-focused investors. Many have seen portfolio losses well in excess of 20% so far this year, and those people who are drawing income from equity portfolios are effectively locking in the worst market losses seen in many years.

Levine says this moment in the markets puts a bright spotlight on sequence of returns risk. Check out the gallery for Levine’s seven top insights about sequence risk, its impact on clients and the ways advisors can respond.

John Manganaro

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Jeffrey Levine: 7 Things to Know About Sequence of Returns Risk

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1. Defining sequence of returns risk is an important step.

Defined in the most basic terms, “sequence of returns risk” refers to the fact that the order and timing of poor investment returns can have a major impact on how long an individual’s retirement savings last.

As Levine explains, the sequence of returns doesn’t matter when there are no cash flows in and out of a portfolio — even when there is extreme volatility. The picture changes entirely when one must factor in systematic withdrawals from the portfolio, whether 4% or any other number.

Sequence risk is especially problematic when a multi-year string of bad returns occurs during the early retirement period. The combination of lower returns and withdrawals quickly adds up to something significant and the portfolio in the aggregate starts to get winnowed down, such that great returns in the future don’t mean nearly as much.

(Image: Adobe Stock)

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2. Sequence risk is commonly overlooked.

According to Levine, the current moment in the equity and bond markets is causing genuine strife among retirement-focused investors. Sadly, Levine says, it is only in moments like these that many clients (and advisors) truly consider what impact sequence of returns risk can have on an otherwise well-crafted financial plan. This is unfortunate, Levine says, because there are few effective levers to pull once a downturn has established itself.

“Sequence risk is one of those financial planning topics that can seem obscure or ancillary relative to other considerations, such as portfolio construction or asset allocation,” Levine says. “In reality, the magnitude of the impact that sequence of returns risk can have on a given client’s retirement success is dramatic. It can be the difference between success and failure.”

(Image: Adobe Stock)

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3. The power of sequence risk is significant.

To demonstrate the power of sequence risk, Levine points to a hypothetical planning exercise in which two identical investors navigate a retirement simulation. Both start with $1 million in assets and follow the 4% withdrawal rule. The simulation assumes 3% annual inflation, and both investors also enjoy a 7% average return during their projected 30-year retirement period.

Now, consider the order in which they receive their returns. Investor A enjoys the most positive years of returns early on and then experiences poor returns later. Investor B starts with negative returns and finishes with highly positive returns at the end of the projection.

“When you run the projection, the two outcomes are shockingly different,” Levine says. “Investor A, with strong returns at the beginning, ends up with something in the range of $2.5 million. The other investor basically depletes their entire portfolio by the end of the 30-year projection.”

(Image: Adobe Stock)

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4. Withdrawals amid bear markets drive sequence risk.

Levine says many clients (and advisors) who hear this thought experiment set up for the first time assume the outcome for each investor is going to be either exactly the same or at least very close. However, this assumption overlooks the critical role that annual withdrawals play in the life of a portfolio.

As Levine explains, it is the combination of the power of lost compounding opportunity with the steady loss of principal caused by income withdrawals from depressed portfolios that makes sequence of returns risk so potent.

Levine points out that this mechanism means sequence risk can have its upside as well. “If you have unexpectedly positive returns early on during the retirement period, your overall retirement outcomes will strongly benefit from that,” Levine says.

(Image: Adobe Stock)

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5. Advance planning is critical.

Levine says discussions about sequence of returns risk can be scary for clients to hear, especially when they are newly retired or are just about to retire. He says good advisors will be working with their clients many years before and after the retirement date to put some helpful strategies in place that can meaningfully mitigate sequence risk.

Beyond the basic bucketing strategy, one protection principle Levine highlights is to maximize the utility of guaranteed income sources. The more guaranteed income one has in place during the early retirement period, the less one will have to rely on the investment portfolio to generate required income.

In practice, Levine says, this can be a delicate balancing act, given the potential importance of delaying Social Security payments. Ideally, one will either work long enough to be able to retire with full benefits or be able to utilize other assets as a bridge to the full claiming age.

(Image: Adobe Stock)

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6. Portfolio tweaks can help.

In terms of fixed income investments, Levine says, a shift towards higher quality and shorter duration is a decent means of mitigating sequence risk on that side of the portfolio. This helps with sequence risk because these assets have a narrower range of expected returns, which reduces the risk that interest rate changes will dramatically damage the value of a given bond fund.

Levine says one option on the equity side of the portfolio is to tilt towards small-cap value stocks, which can help mitigate sequence risk because these stocks have a higher expected return over time than larger companies with higher price-to-earnings ratios.

“The idea is that, by purchasing a small value company, you pay less for the same amount of projected earnings, and you can expect your investment to have a greater return over time,” Levine says. “And so, by tilting a portion of the portfolio in this direction, you can potentially then increase the overall amount of safer investments while still having a similar overall expected return.”

(Image: Shutterstock)

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7. Working longer and spending less help.

“Sadly, once a bear market establishes itself, there are few options for retirees apart from cutting spending or seeking additional work opportunities,” Levine says. “These are both viable options for many people, but they are obviously not preferred. It is much better to try and prepare in advance.”

Extending one’s working life is a powerful option, Levine says, but it is not always feasible or desirable, depending on the individual facts and circumstances.

Perhaps the method most directly in the control of any given retiree is the effort to cut down on living expenses in retirement. Levine says this is another impactful way to protect retirement savings during difficult moments in the market, as it may take as little as $250 or $500 in reduced monthly expenses to significantly extend the life of a given investor’s portfolio.

(Image: Shutterstock)

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