Timing is everything, so the saying goes. This is especially true when it comes to your retirement. Many people may not understand the role timing plays in a successful retirement plan. While most tend to focus on the average return of investments it is often just as important to pay attention to how you achieve those returns.
The timing of when someone retires can have a profound effect on the performance of their accounts. Sequence risk, also known as sequence of returns risk, pertains to the timing of returns during the withdrawal phase. For example, if you retired in 2000, you may have already run out of money. Surprisingly, it’s a completely different story if you retired just a few years earlier or a few years later.
To illustrate the impact of sequence risk, here’s the story of three hypothetical brothers each born three years apart. Each brother retired at age 65 with a $1 million lump sum pension, which they invested according to Standard & Poor's 500-stock index models. Upon retirement, they immediately began taking monthly withdrawals of $5,000, on the same dates of each month. But the results, you will see, are very different.
The oldest brother retired in January 1997. As of the end of February 2018, he has withdrawn $1.27 million in income, and his remaining balance is currently about $2.04 million, or roughly two-thirds more than his starting value.
The middle brother retired three years later, in January 2000, and followed the same strategy of taking a 6% monthly withdrawal. However, he did not make out as well. He only withdrew $987,342, considerably less than the oldest brother, but has completely run out of money.
The youngest brother finally retired in January 2003 and also began taking 6% monthly withdrawals. As of the end of February 2018, he had withdrawn $910,000 and has approximately $2.05 million remaining in the account.
Why did the oldest and youngest brothers succeed while the middle brother ran out of money? One of the greatest contributing factors is the market performance during the first three years of retirement. The oldest and youngest brothers began taking withdrawals in 1997 and 2003, respectively, when the markets were doing very well, and their retirement portfolios reaped the benefits.
The middle brother, unfortunately, began his retirement just as the economy was plunging into a full-on recession. The markets dropped drastically, and so did the value of his retirement savings.
While no strategy assures success or protects against loss, there are techniques that can help to mitigate sequence risk. One way is to incorporate a fixed-income component of your portfolio, such as cash or a multi-year bond ladder that is designated for providing income when the markets are down. If the market recovers in a relatively short period of time, this buffer may protect you from having to sell equities at a depressed price. Keep in mind bonds are subject to market interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.
Another strategy is to utilize a product, such as an annuity, that can help to provide a lifetime income stream and reduce the withdrawal need from the overall equity portion of your portfolio. The longer you receive the income stream, the greater possible rate of return on the investment. Conversely, the longer you draw from your equity portfolio, the greater the chance of running out of money.
If history has taught us anything, it’s that no one can predict how the market will perform. Since crystal balls cannot foretell how your investments will fare in your first few years of your retirement, it’s best to turn to your financial adviser for advice on how the techniques described herein and others can help reduce your chance of ending up like brother #2.
This example was calculated in Morningstar Advisor Workstation as follows: $1M initial investments on 1/1/1997, 1/1/2000, and 1/1/2003 in S&P 500 TR USD (IDX), $5,000/monthly withdrawals starting immediately and ending on 2/28/2018.
This example is for hypothetical purposes only. It is not intended to portray past or future investment performance for any specific investment. Past performance is no guarantee of future results. You cannot invest directly in an index and your own investment may perform better or worse than this example. This example does not include the deduction of fees, charges inherent to investing, taxes or investment costs which could have a dramatic effect on your results.
Stock investing involves risk including loss of principal.
Securities offered through Mutual Securities, Inc., Member FINRA/SIPC. MACRO Consulting Group, LLC is not affiliated with Mutual Securities, Inc.