The stock market downturn that stretched from late 2007 through early 2009 gave recent and soon-to-be retirees a harsh lesson in the dangers of sequence of returns risk. That’s the risk that poor investment returns at or near retirement age will devastate your portfolio and result in you outliving your savings. It makes a strong argument for including a sizeable chunk of conservative assets—things like annuities, perhaps, or stable value funds— in your portfolio at that stage of life.
But Dirk Cotton, a retired Fortune 500 executive and now an author, financial advisor and founder of the retirement blog The Retirement Café, says sequence of returns risk doesn’t just haunt those nearing or in retirement. It also impacts investors throughout the accumulation phase of retirement planning, albeit perhaps not as dramatically.
By way of example, Cotton sketched out two examples during a talk at the SVIA’s 2015 Fall Forum, one representing an investor adding $12 to his $100 portfolio each year and another withdrawing $12 annually. For each example, he calculated the best and worst possible ending values knowing the annual returns for each of those five years but not the order of the returns. For the portfolio in which the investor was withdrawing money, the ending balance ranged from a high of $48.49 to a low of $34.92. For the portfolio getting $12 in new contributions each year, the best finish was $162.41 and the worst $158.38.
Cotton pointed out that sequence of returns risk is most dangerous during the first 10 years of retirement because that is when retirement portfolios are largest—and because losses can compound for decades. The risk is smaller later in retirement because portfolios are smaller with less time for losses to compound. It also tends to be less dangerous in the accumulation phase of retirement investing, in part because, again, portfolios tend to be smaller then.
Individuals can largely eliminate sequence of returns risk, Cotton observed, by investing exclusively in conservative investments such as insurance contracts, inflation-protected securities such as TIPS, or annuities. That eliminates most downside risk but also a lot of upside potential, making it difficult to leave a legacy or simply to make sure your standard of living keeps pace with inflation.
Cotton suggested a more practical approach, which is to create a “floor” of retirement income with very conservative investments—supplementing any Social Security or pension income to which one might be entitled—and then invest any remaining assets in volatile investments such as stocks, bonds, commodities and real estate investment trusts.
While some academics argue that an income floor sufficient to cover fixed living expenses should make retirees comfortable allocating 100% of their remaining money to volatile assets, Cotton disagrees. He observed that in his own case, he would not have been happy if his volatile portfolio had fallen, say, 50 percent in value the first year after he stopped working. “After you retire you feel differently about it,” he said. “You need to dampen the volatility of your portfolio just to sleep at night.”
Cotton outlined a number of strategies that investors and retirees can follow, beyond the floor-and-upside approached described above, to mitigate the risk of outliving their assets.
Under one approach, retirees can withdraw a fixed percentage of their portfolio each year—4%, adjusted annually for inflation, is a common rule of thumb—rather than a fixed dollar amount. The downside is that their standard of living may fluctuate from year to year and they may end up, upon their impending death, with a lot of money that could have been used to raise their standard of living. “They might think, ‘Wow, I wish I’d spent more,’” he said.
Still, that’s probably better than running out of money before dying. “As long as you don’t do that,” Cotton said, “you will have successfully funded retirement.”