Investment Insights

Sequence Risk May Be The Biggest Problem For Retirees
by Mike Jones

Over the next several years professionals in the financial services industry are going to be called upon to solve an extremely difficult problem: providing income to millions of retirees who have placed the majority of their life savings into publicly traded securities.With interest rates still hovering around historical lows and stock market prices setting record after record, it is correct to ask, “Where do we go from here?” and “How in the world do we attempt to sustain a fixed or inflation adjusted standard of income from a portfolio of volatile assets?”

The problem is one of simple math. As stated above, millions of investors are depending on investment returns from volatile assets to deliver income from the time they retire until their death. Using averages for investment returns or simulations that work 85% of the time provides no comfort to such investors. It is the sequence of returns that matters most.

What good is it to a retiree to make 50% on your life savings if you have lost 50% the prior year? That would mean your $1,000,000 fund is worth $650,000 after just two years (assuming a 4% distribution rate). Keep that up and you will be broke before you know it. Avoiding a large negative return in the early years of one’s retirement is CRITICAL to making the money last.

Dr. Wade D. Pfau, CFA®, is a Professor of Retirement Income in the PhD in Financial and Retirement Planning program at The American College of Financial Services. He is also a contributor to the College’s Retirement Income Certified Professional® (RICP®) designation program curriculum.

Dr. Pfau graciously shared information from his forthcoming book, How Much Can I Spend in Retirement, to subscribers of the FA (Financial Advisors) website. In the article “Managing Sequence Risk for Retirees,” Dr. Pfau suggests four techniques retirees may employ to mitigate the threat of running out of money in retirement:

1.Spend Conservatively. This techniques advises investors to keep reducing the amount they distribute from a portfolio the more aggressive they make that portfolio. At least at first. This allows the more aggressive investment strategy time to succeed thus enabling the investor a chance to harvest bigger sums down the road. While this is mathematically feasible, it is highly impractical for most retires.

2.Maintain spending flexibility. This approach only works for those retirees who have other sources of income. It espouses a fluctuation in income that is mirrored to the fluctuation in return.  If you have a meager year in performance you take out a meager distribution.  If you have a robust year, it’s party time. This greatly reduces sequence risk but is an option only to a small percentage of investors.

3.Reduce Volatility (when it matters most). I actually like this one and subscribe to it in many cases. A portfolio of reduced volatility risk is a portfolio of reduced sequence of return risk. This concept can be applied two ways. The first is to greatly reduce the risk factors during the early years of retirement. Since it is the investment returns during the first 5 to 10 years of retirement that reek the most havoc on the eventual outcome, then why not just lower the risk? One can also reduce volatility after a period of economic growth and market expansion, i.e. dynamic asset allocation. Not losing money when others are can certainly benefit a retirement portfolio as money will be available to make investments when they become attractive again. Please don’t try this one on your own. It must be applied with discipline.

4.Buffer Assets. This final technique encourages investors in the securities markets to buffer against down markets by setting aside money that can be a resource when markets turn down. The return on these assets cannot be correlated to the securities market as they would not provide a buffer if that were the case. In other words, diversify. But diversify intelligently. Many investors forget that last admonition.

The road ahead for retirees and their investment professionals is going to be a tricky one. We know that. Fortunately, many brilliant minds are thinking ahead to ways to avoid the worst of those potential problems.

If you are nearing retirement and haven’t done so already, talk with your financial advisor about his or her recommendations on how you should approach tapping into your retirement savings to best avoid sequence risk.