Managing the sequence of return risk in your retirement planning process

I am not a gambler.  But I have seen it close enough to understand how and why so many people struggle with gambling addictions.  Several years ago, my wife and I joined a few other couples from our church for a two-night stay during the “cheap week” at The Greenbrier Resort in White Sulpher Springs, WV.  Rooms that were typically hundreds of dollars per night were available for the cost of a stay at a Hampton Inn for just one special promotional week to keep the summertime resort filled in the winter months.  Since nearly all of the outdoor resort activities were offline during February, we had to find some indoor entertainment. 

The choices available were to go to a movie in the nearby town or visit the new hotel-casino recently added.  We all agreed that if we went to the hotel-casino, we could all put in $20 (about the cost of movie tickets and snacks) and watch and cheer for one of us to play the roulette table.  For the non-gamblers, the roulette table is the black and red spinning circle.  You can bet chips on the spinner hitting a certain number (lower odds, but higher payoff), or you can simply bet on the color (red or black).  Our game was to see how long our collective group funds would last by simply playing a color.  The goal of our little experiment wasn’t to win a bunch of money; instead, we hoped our “movie-ticket-pot-of-cash” would last for a few hours of entertainment. When it was gone, it was gone, and we were committed not to adding anything more.  Long story short, our money DID last as long as we hoped it would, even though there were many ups and downs throughout the night. 

As a non-gambler, I realized that the trick to stretching our funds out for the night was that if we lost early on, we had to double our bet and win to break even on the next play.  If we lost two in a row, we had to double again.  If we hit a long streak of losses, we would be depleted quickly and wish we had opted for the movies!

Understanding The Game

I think our experience at the roulette table illustrates an important concept in retirement planning known as sequence of return risk, the risk associated with unfavorable sequencing of returns in our retirement portfolios.  Because of the time value of money, unfavorable returns at the early stages of retirement sting much more than unfavorable returns experienced later in retirement.  For example,

• If the investor loses 40% in 1 year, to get back to even next year, they need to make 67%

• If the investor loses 50%, they need 100%

• 60%, 150% to get back to baseline

So much of finance is behavioral.  When we are in the wealth accumulation phase, we work hard and save.  When we are in the wealth decumulation phase, we spend and give.  But what are the right behaviors for the transition period between wealth accumulation and decumulation?  How should we plan for those final years before retirement to manage a successful transition?

Understanding The Stakes

The average returns over the life of a retirement portfolio are important.  But, the most important factor is the actual impact of the order of positive and negative returns in the last few years leading up to retirement.  In the financial planning world, this risk is known as sequencing risk, the Red Zone for retirement income planning.  The last 10 years before retirement represent this red zone for portfolio risk. 

According to a research paper compiled by Griffith University authored by Brett Doran, Michael Doran, and Adam Walk, the adverse return to a portfolio during those last years has an enormous potential for negatively impacting a portfolio.  The research study evaluated the effect on a hypothetical retirement portfolio value (accumulated over various saving periods) to a single shock of a  -21.6% return at the retirement date.  The findings were astonishing!  According to Dr. Walk’s research, the result was that in evaluating the same 40-year accumulation period (working years before retirement), subjecting the portfolio to a single negative return of -21.6%  halfway through one’s working life/savings period (20 years into the total 40-year accumulation period) the -21.6% shock reduces the portfolio value by 16%.  But, the same one-off shock sequenced later…at the end of the 40 years of saving, reduced terminal wealth by 24%.  What does this show us about sequencing?

Why does this matter?  As Dave Ramsey says, the ultimate goal of building wealth is to be able to one day “Live and Give like no one else!”  In other words, the BIG IDEA underlying an evaluation of retirement red zone risk (sequencing return risk) is simple: A secure and fulfilling retirement means being able to have confidence that your money won’t run out and that you can live and give generously without succumbing to fears of the unknowns of the stock market.

The tested probability of a retirement portfolio meeting income needs at age 85 showed that:

• Shock 15 years into retirement resulted in a 33.5% chance of portfolio ruin

• Shock at retirement resulted in a 50.6% chance of portfolio ruin

Increasing Your Odds

So, how should investors think about managing their own sequence of return risk in their retirement asset portfolio?  Investors should consult with a financial advisor regarding potential solutions for managing the sequence of return risk during the Retirement Red Zone.

Here are a few potential solutions to consider:

• Lowering the allocation to equities during the time-period

• Changing the allocation to equities based on the prices of equities

• Changing the allocation to equities based on whether plan funding goals have been met

• Further diversifying portfolios by adding asset classes (like real estate or private credit), reducing the standard deviation of the portfolio

• Retiree must be able to tolerate variability of income

• Income annuities

• Buffer assets

  • Cash

  • life insurance

  • reverse mortgages

• Provide Downside Protection

  • Use Derivatives such as Put Options to limit losses

  • Deferred annuity with withdrawal benefit rider

• Spend conservatively: Lower withdrawal rate. (For more on the safe withdrawal rate, see the Journal of Financial Planning article on William Bengen’s “Safemax” Portfolio Withdrawal Rate

Don’t gamble with your retirement!  Whether you are entering the Red Zone or just beginning to build your retirement portfolio, you need to find a trusted Financial Advisor who can help you plan the work and who will then help keep you committed to working that plan together. 

At Whitaker-Myers Wealth Managers, our team can assist clients through various aspects of financial management, retirement income planning, and tax advice.  If you are interested in speaking with a financial advisor, schedule a conversation today.