Investors planning for long-term goals like college or retirement must cross a minefield of risks: inflation, economic downturns, fraud, putting too many eggs in one basket.
At the heart of any strategy are assumptions about investment return over time. Guessing wrong can be a disaster.
But there’s another risk that’s easy to overlook and impossible to predict: sequence risk, also referred to as sequence-of-returns risk. That’s when an investment with a perfectly respectable return plunges at the wrong time, like the moment the investor will need to withdraw funds.
The stock market collapse of 2009 is a prime example. Even though it recovered fairly quickly, investors who had to withdraw funds during the downturn may still not have healed completely.
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“Sequence-of-returns risk is the risk of receiving lower or negative returns early in a period when withdrawals are being made from an individual’s investment account,” says Robert R. Johnson, president of the American College of Financial Services in Bryn Mawr, Pennsylvania. “Essentially, it recognizes that the order of returns matters, particularly when one is approaching a seminal point like the retirement date.”
Dave Buckwald, a senior partner at Atlas Advisory Group in Cranford, New Jersey, says the issue is particularly important today because many investors, including those in retirement, have heavy emphasis on stocks due to low yields on bonds, which have traditionally been a mainstay in retirement accounts. Also, the steady rise in stocks since the depths of the financial crisis have increased stock allocations in many investors’ portfolios.
“While increases in the percentage of equities held has historically increased long-term returns, if you’re near retirement it can introduce a dangerous level of volatility within your portfolio,” Buckwald says. “So while a stock-focused strategy may make sense for someone still saving for retirement, the game changes when it’s time for retirement distribution.”
Imagine a portfolio that fell by 50 percent in a crash, owned by an investor who’d planned on taking out a lump sum annually for ordinary expenses, starting at 4 percent of the portfolio’s value the first year. If the downturn lasted for three years, the portfolio would fall to 38 percent of its pre-crash level because of those withdrawals. It would have to nearly triple to get back to its original size, and further withdrawals would make the recovery even slower.
“Since removing assets from the portfolio during a period of poor performance essentially locks in the loss, the probability of a portfolio recovering from the downturn is greatly impaired,” says John Knolle, principal at Saranap Wealth Advisors in Walnut Creek, California. “An investor encountering this risk early in their withdrawal period may find that their portfolio can no longer sustain the planned withdrawal rate due to its reduced size.”
Some investors are more vulnerable to sequence risk.
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“For most investors with a lump sum investment, sequence of returns risk is a minor concern,” Buckwalld says. “But for retirees who have just begun withdrawing retirement distributions, managing this risk is far more important than seeking greater returns.”
The risk is even worse for investors who are concentrated in just a few stocks or narrowly focused funds, because an individual holding may be wiped out or permanently damaged even if the broad market rebounds.
One way to minimize sequence of return risk is to spread money around through a large number of holdings or funds that own dozens or hundreds of stocks.
Owning other types of assets like bonds may help, since one type of asset may do well when others falter.
“Taking risk off the table right before retirement is a prudent move,” Johnson says. “And appropriate assets may be shorter-duration bonds [because they have less interest rate risk] or Treasury inflation-protected securities (TIPS).”
Experts warn, however that diversification is no guarantee. In a market meltdown — everything might collapse.
“With the globalization of financial markets, the empirical evidence shows that global financial markets are becoming much more highly correlated,” Johnson says, meaning stocks, bonds and other assets can all drop at the same time. “And, as markets become more highly correlated, the diversification benefits of spreading investments across global markets also decline.”
Another strategy is to try to minimize expenses to be able to live on less to avoid big investment withdrawals during a downturn. Most important is to cut expenses that cannot be trimmed on the fly, like the mortgage and other costs of owning an expensive home.
Investors can also look for ways to increase guaranteed income with immediate or deferred annuities, or stocks or funds likely to continue paying dividends even if share values fall. Utility stocks have long been prized for their reliable dividends, for example, though nothing is guaranteed. Delaying the start of Social Security benefits, however, does offer a guaranteed increase in retirement income, Buckwald says.
“You mitigate risk by not putting all your money in the market,” says Michelle Morar, owner of Innovative Insurance Solutions in Greensboro, North Carolina. “Take a portion of your money and put it into an immediate annuity to cover basic expenses because that money will last as long as you do.”
Immediate annuities pay a monthly income for life in exchange for an upfront premium. Deferred annuities pay more but don’t start for a number of years.
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Buckwald also suggests holding some assets in Roth individual retirement accounts and 401(k)s, because tax-free treatment of withdrawals will help investments last longer by avoiding withdrawals to pay taxes. Also, Roth accounts do not face required minimum distributions after age 70½, allowing those investments more time to grow and strengthen the portfolio against a downturn.
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Why Sequence Risk Matters originally appeared on usnews.com
