As with most things in life, timing is everything when it comes to retirement. Sequence of Return Risk is the danger that the timing of withdrawals from retirement accounts will have a negative impact on the overall rate of return and assets available to an investor. Retire in a bull market and you will probably be enjoying life, but retire in a bear market and the picture might not be so rosy. Since we can’t predict the future it’s important to be prepared for whatever market you encounter during retirement. Below we discuss the Investor Lifecycle, what it means, and how you can avoid sequence of return risk and enjoy the retirement you deserve.
The Investor Lifecycle
The Investor Lifecycle is comprised of three distinct phases. Phase one is known as the Accumulation Phase. In this phase, typically lasting 35-40 years, you focus on growth for the future. The Preservation Phase, Phase Two, is when you prepare for retirement. During this phase, it becomes more and more prudent to reduce risk taking and increase your participation in protective investment strategies. The third and final phase is the Distribution Phase. This period of a person’s life is where they will transition from earning their income to taking it in large part from their retirement savings. This phase is critical to examine because at this point there is no attractive way of turning back should something go awry.
The Sequence of Return Risk: The Importance of Timing
During the Distribution Phase, it is especially important to be aware of Sequence of Return Risk. As a reminder, Sequence of Return Risk is the risk that the timing of withdrawals will have a negative impact on your portfolio’s value. It is specifically down markets that have a significant impact on a retiree who depends on taking income from their investments because they are withdrawing funds from a continuous shrinking pool of assets. The return needed to recover these losses grows as losses mount.
For example, imagine you retire at the beginning of the 2000 Bear Market with $1 million invested in the S&P 500. You plan to take out $50,000 a year and increase your withdrawal by 3% every year for inflation. The bad news is your nest egg would be gone by 2016. However, if you replace those terrible years from 2000-2002 with 2014-2016 it is a completely different story. Today your portfolio would still be over $1 million vs $0 in 2016.
How to Mitigate Sequence of Return Risk
The good news is you don’t have to let the market determine whether you spend your retirement on a beach or worried about paying bills. There are a number of ways you can limit the damage of sequence of return risk depending upon where you are in the Investor Lifecycle. Below we highlight some of the most common and the pros and cons of each.
Buy and Hold Strategy
In a buy and hold strategy, you buy stocks with the intent to hold on for the long-term. If you are in the early stages of the investor lifecycle, with lots of time on your hands, this strategy can offer returns with fewer headaches and can be great for taxes. However, if you lack time to make up any potential losses this strategy places you at the mercy of the market.
Use Bonds
Another common strategy is allocating a portion of your portfolio to bonds. In theory, the more bonds you have in a portfolio, the less volatility you will be exposed to in the market. However, remember that every decision in investing comes with a tradeoff. As you dial up the proportion of bonds in the portfolio, the tradeoff is a lower expected long-term return. In a declining interest-rate market, will that lower return be enough to cover your needs?
A Tactical Approach
A tactical approach aims to preserve capital during times of high risk through the use of cash and cash equivalents. The percentage of the strategy invested in the stock market may vary depending upon the prevailing risks in the market. This strategy can offer you reduced volatility and capital preservation during those critical distribution years but in rocky markets, you might occasionally miss some upside potential.
The Next Step
At the end of the day, the goal is not to beat an index but instead have a strategy in place that allows you to sleep at night and achieve your goals. Accomplishing these goals involves understanding where you are in your Investor Lifecycle and evaluating the trade-off between risk and return. Can you ride out the market in the hopes of superior returns? On the other hand, would you rather limit your risk and minimize losses? Once you have those answers, put your investment strategy into place.
About Churchill Management Group
Churchill Management Group was founded in 1963. Our Firm and/or Portfolio Managers have been named Barron’s #1 Top Independent Advisor in 2016 and ranked #1 Best-in-State Advisor: CA – Los Angeles in 2020 and #13 on Forbes list of America’s Top 250 Wealth Advisors in 2019.* It is our mission to grow capital in favorable markets and protect in less favorable high-risk environments through our tactical strategies.
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