This article will ...
- Define sequence of returns risk and explain how it can adversely affect your retirement income.
- Note the benefits of diversification and the importance of having a mix of assets as you approach retirement.
- Explain the benefits a deferred income annuity can offer to ensure a guaranteed stream of income in retirement.
Many people aren’t prepared for these scenarios because they aren’t aware of the threat they pose. You know you’re supposed to save a good chunk of every paycheck for retirement. And you know that the odds favor better performance for your portfolio if you buy and hold your investments and don’t let your emotions convince you to sell when the market underperforms.
But there’s a good chance you’ve never heard of sequence of returns risk.
Sequence of returns risk is a fancy way of saying that it matters not only how much your retirement portfolio earns each year on average, but how much it earns in any given year. It’s not a major concern in the decades leading up to retirement because you’re only adding to your portfolio, not withdrawing anything from it. But it becomes a concern when you’re nearing and entering retirement. If the stock market is down in the early years of your retirement and you have to sell stocks at a loss to get enough income for your basic expenses, you can really hurt your portfolio’s value in both the short run and the long run. (Related: More on sequence of returns risk)
Why returns near retirement matter so much
If you are within five years of retirement, you are in the “retirement red zone,” said Robert R. Johnson, president and CEO of the American College of Financial Services in Bryn Mawr, Pennsylvania, in an interview. He also suggested such investors consider de-risking their portfolios to help protect against a large, negative market event. “You simply can't afford to make a big mistake when you have a short time horizon to retirement.”
Consider two hypothetical retirement portfolios, each with a starting value of $500,000.
For both portfolios, the owner withdraws $20,000 in year 1 and increases withdrawals by 2.4% percent each year to account for inflation.
Portfolio 1 experiences the following annual returns during the first five years of retirement:
Portfolio 2 sees annual returns of:
After five years, Portfolio 1 is worth $284,655, while Portfolio 2 is worth $727,163.
Portfolio 1 continues to experience several losing years early on, while Portfolio 2 continues to experience considerable gains.
Despite the annual drawdowns, Portfolio 2 has actually increased in value 10 years into retirement: it’s worth $1,077,704. Meanwhile, Portfolio 1 is worth just $140,814.
These results offer a compelling example of how the sequence of returns can affect your retirement portfolio. (See the full illustration of this example here)
Some people take advantage of cash value life insurance to avoid tapping investment funds during down market cycles. (Learn more: How life insurance can supplement your retirement income)
Portfolio diversification can help protect you
If your portfolio is well diversified with assets that tend to perform differently from each other — international stocks, small company stocks, large company stocks, bonds and real estate — then when one asset class is losing value, you can rely on holdings in another asset class that are more stable or perhaps increasing in value. This will provide the poorly performing assets a chance to recover and may allow you to avoid selling them at a loss. (Related: Fix your mix)
Suppose you need to withdraw $50,000 from your portfolio to pay for your housing, food, utilities, health care and other basic expenses. Now, let’s say the value of the shares you were planning to sell recently plummeted from $50 a share to $40 a share: a 20 percent drop. Instead of selling 10,000 shares to get the $50,000 you need, you have to sell 12,500 shares. That’s 2,500 fewer shares in your portfolio that can rebound and help you make up for your losses.
Now, imagine that this scenario continues for several years: the effect can be devastating. If it happens early in your retirement years, your portfolio might never recover. But if you have other stable assets that you can rely on, then the rest of your portfolio can have an opportunity to recover.
Similarly, while you’re still working but getting close to retirement, if returns are terrible and your portfolio is not well diversified, you might find that your portfolio balance is too small to allow you to retire. This possibility is called retirement date risk. You might determine that you have to work several years longer as a result while you wait for the stock market to recover.
If you are unable to continue to work you might find that your retirement savings will not last as long you hope. On the plus side, if you can keep working, you’ll have several extra years of savings to add to your nest egg, and you may be able to use that money to buy stocks that can appreciate in value if the stock market rebounds. (Related: Crazy stock markets? Count your financial eggs)
Asset allocations for near-retirees and recent retirees
While there is general agreement that diversification is a benefit for investors, there are different viewpoints about what the right mix and asset allocation should be for those at or near retirement. These arguments usually center on the balance between stocks and bonds.
“Some retirees make the mistake of entirely getting out of the equity markets when approaching retirement, and that is not a prudent strategy,” Johnson said. Given that many retirees live for many years past retirement, having an overly conservative asset allocation means that you risk outliving your assets.
On the other hand, stocks (and equity-related mutual funds) involve an assortment of risks ranging from individual company performance to industry-specific factors to the fitness of the general economy. Individuals should take into account these risks when considering various strategies for investing, especially near retirement. More conservative approaches may be more appealing. (Related: Understanding asset allocation )
“As an individual nears retirement, they should consider reallocating some of their equity holdings to high dividend yielding stocks,” Johnson said. If paid, dividends could help supplement your income, and the prices of many dividend-paying stocks have generally increased over time. Dividend amounts also generally have increased over time. Indeed many (but not all), blue-chip companies (listed in the Dow Jones Industrial Index) have had a long history of increasing their dividend payments to shareholders each year. Such increases may help protect your portfolio’s value against inflation. Of course, history is not a guarantee of future performance.
Stocks of companies that have good free cash flow are another option to consider if you don’t mind doing the research on individual stocks. When a company’s free cash flow – the money available after a company makes payments to sustain its business — is increasing, it can be a good sign for the company’s future value and its stock’s future value. It helps a company grow in good times and survive in challenging times. Free cash flow also enables a company to pay dividends, if it chooses, and to increase its dividend payments.
A relatively new theory to consider is lowering your portfolio’s stock allocation to a low range, say 20-30 percent, and increasing your bond allocation to a relatively higher range, say 70-80 percent, in the years just before and after retirement — instead of following the conventional wisdom of allocating 100 minus your age to stocks and the rest to bonds. Then, as you age, you increase your allocation to stocks and decrease your allocation to bonds. Called a “rising equity glide path,” retirement experts Wade Pfau and Michael Kitces argue that this strategy can help protect against the risk of running out of money, particularly when stock market returns are poor early in retirement.1
Stocks tend to offer higher returns than bonds in the long run, but they tend to be more volatile: they can gain or lose a lot of value in a short time. In the years just before and after you retire, you want to be sure you have something whose value is relatively stable to help counter sequence of returns risk.
Possible protection with deferred income annuities
Besides diversification and asset allocation strategies, you can protect against sequence of returns risk and retirement date risk by purchasing a deferred income annuity. Deferred income annuities (DIAs) are sometimes called longevity insurance because they help protect against the risk of running out of money later in retirement. This type of annuity provides guaranteed income, whereas your retirement portfolio may not, depending on how the market performs.
Johnson said that people who are approaching retirement should consider purchasing an annuity as a source of guaranteed income to help cover their basic living expenses in retirement. He said they can be excellent vehicles to ensure retirement income. Also, annuitizing part of your portfolio lets you be more aggressive in allocating the rest of your portfolio, he said. (Related: Does an annuity fit your retirement goals?)
If you don’t have a guaranteed income from a pension and your monthly Social Security payments aren’t enough to cover all your expenses, a deferred income annuity can offer peace of mind and financial stability. In exchange for a lump sum or a series of up-front payments, you will later receive a steady, predictable annual income. The tradeoff, however, is that there is little to no liquidity. You should ensure that you have a source of liquid assets for emergencies.
An annuity could also protect you against retirement date risk by guaranteeing income starting early in retirement. In this case, you might buy a few years before retirement a deferred income annuity that would start making payments in the year you plan to retire. It will cost more, but you’ll receive income sooner.
That’s because the longer you’re willing to wait to start receiving payments, the less a deferred income annuity typically costs. (Learn more about annuities here)
Additionally, many people are concerned about losing their initial investment if they die before an annuity begins to pay out or after it starts paying out but before getting their money’s worth. Your heirs would receive less than they might have had you not purchased the annuity. But many annuities reduce this risk by offering a death benefit, such as a return of some or the entire principal to your heirs upon death if you haven’t started receiving income payments yet. Even if you have started receiving payments but the payments haven’t reached the amount of premium you paid, your heirs may receive a refund of the unused premium.
It’s important to protect your retirement portfolio against the possibility of a market downturn in the years immediately before and after your retirement. Proper diversification, asset allocation, and possibly a deferred income annuity can help manage these risks.
1 Wade Pfau and Michael Kitces, “Reducing Retirement Risk With a Rising Equity Glide Path,” Journal of Financial Planning, Vol. 27, No. 1: 38–45.