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Advisors can help retirees mitigate sequence risk – and successfully navigate market swings.
Navigating the landscape of portfolio risk is critical for clients to obtain financial success. We are familiar with common risks that may affect client portfolios: market, credit, liquidity, economic and geopolitical risk, all of which can be hurdles to achieve your clients’ portfolio objectives.
But there is one often-overlooked risk – sequence risk – that can significantly threaten your clients’ retirement savings. Sequence risk refers to the threat of going broke due to the timing of market fluctuation during the withdrawal phase of your clients’ retirement investments.
It is driven by the order in which investment returns occur and can significantly impact portfolio outcomes, especially for retirees. Experiencing poor market performance early in retirement makes it challenging to maintain income sustainability, even if the market recovers later, and can deplete your client’s portfolio faster.
One way to illustrate how sequence risk affects your clients’ portfolios, especially for pre-retirees and retirees, is to put an investment spin on one of my favorite bedtime stories as a kid, Aesop’s “The Tortoise and The Hare.”
In my telling, a 65-year-old tortoise tells all her friends in the forest that she will soon retire. Meanwhile, a hare, munching on a carrot while leaning against a tree, overhears the tortoise and loudly proclaims, “I am retiring too, and although we are both starting with $1 million, I should have much more income in retirement than you!”
The hare laughed at his joke, but he got under the tortoise’s shell. The tortoise took the hare up on his challenge, and their remarkable retirement journey began, each allocating $40,000 annually for income with a prudent 2% increase each year to combat inflation. An intriguing tale of financial strategy began to unfold.
Oddly, the tortoise and the hare experienced the same return patterns with 10 years of a 6% return, 10 years of a 3% return, and 10 years of a flat 0% return.
But the difference between the tortoise and the hare was the sequence of these returns.
The tortoise started with 10 years of a 6% rate of return, followed by 10 years of a 3% return, and then 10 years of a flat 0% return.
On the other hand, the hare started with 10 years of a flat 0% rate of return, followed by 10 years of a 3% return, and then 10 years of a 6% return.
These are the same returns – just a different sequence. Even in Aesop’s fables, math works the same way it does in the real world.
Remarkably, both the tortoise and the hare averaged an identical 2.97% rate of return.
Yet, the devastation caused by sequence risk when taking retirement distributions was considerable. Although neither the tortoise nor the hare experienced a negative return in their retirement years, because of the hare’s sequence of returns, starting with 10 years of a 0% return, then 10 years of a 3% return, and finally 10 years of a 6% return, he went broke 23 years later. He ran out of money at age 88.
Despondent and no longer having money for carrots, the hare tried to get a part-time job as a “hare dresser” but was too old to be hired. Out of desperation, he had to move in with the tortoise.
On the other hand, the tortoise – with the same 2.97% average rate of return but a different sequence of returns, starting with 10 years at 6%, followed by 10 years at 3%, and then 10 years at 0% return – still has plenty of assets after 30 years.
In fact, if we assume a 0% return from age 85 going forward, the tortoise will not run out of money until she is 105 years old, an impressive age by human and hare standards but average by tortoise standards. Our shelled friend’s fortunes rested on her sequence of return, besting the hare at the delight of her forest friends, who never really cared much for the hare.
The moral of this story is for financial advisors to be keenly aware of sequence risk and its often-overlooked danger. Even if two individuals experience the same average rate of return over their retirement years, the order in which those returns occur can significantly impact the sustainability of their portfolios.
The story is a reminder of the timing of market fluctuations during the withdrawal phase. It underscores the potential impact of poor market performance early in retirement, highlighting the need for strategic planning to mitigate sequence risk and extend retirement savings.
Advisors should consider not only the average returns but also the sequence in which those returns are realized to help protect their clients' financial health over the long term.
The important role advisors play
There is one part of my take on “The Tortoise and The Hare” that I left out.
The tortoise’s financial advisor, who was the wise owl, considered a diversified portfolio of stocks and bonds designed to adjust equity exposure depending on market performance. The strategy was driven by an algorithm created to identify the potentially best opportunities for buying into and selling equities, inspired by Warren Buffett, who once said, “Be fearful when others are greedy, and be greedy when others are fearful.”
The owl’s strategy was designed to own fewer equities when the market cycle hits its high and increase equity ownership when the market cycles to the bottom and starts climbing back up. This type of strategy attempts to help investors in the real-life forest speed up their recovery from market downturns.
The sequence of investment returns just before or during retirement can make or break a client’s retirement readiness. Making sure investors start with healthy returns in retirement is key. Advisors can make all the difference by educating their retired clients and those nearing retirement about sequence risk through investment strategies that can potentially mitigate this threat.
Salvatore M. Capizzi, CEPA is executive vice president of Dunham & Associates Investment Counsel, Inc., a wealth management and trust services firm which has been challenging the industry’s thinking for nearly four decades.
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Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.