In this month’s edition of “Money Matters,” Scott explains sequence of return risk and why it is critical to include in your retirement financial planning process.

Who is Affected by the Sequence of Returns?

It’s important to understand how returns and withdrawals may affect your portfolio.

The sequence of returns may have less of an impact on the portfolio of someone who is still working and accumulating assets for retirement; however, during retirement, the relationship between an individual’s rate of withdrawal and the sequence of returns can have a dramatic impact on a portfolio’s overall ability to last. It is, therefore, very important to understand how it may affect your future lifestyle and plan accordingly.

Source: John Hancock

Money Matters: Sequence of Return Risk Transcript

0:00:00.1 CJ: WTIP is pleased to bring you another edition of Money Matters, a monthly feature intended to help us understand more about managing our finances. Scott Oeth is a certified financial planner and adjunct professor. He works with many individuals and has taught retirement planning and wealth management strategies to hundreds of financial professionals, and Scott joins us now by phone. Good morning, Scott.

0:00:24.4 Scott Oeth: Good morning, CJ.

0:00:25.9 CJ: So, you said you wanted to talk about sequence of return risk, and I wanna know what is the sequence of return risk?

0:00:37.1 SO: Well, CJ I have a question for you. Did you want the good news or the bad news first

0:00:41.9 CJ: Ooh, let's start with the good news.

0:00:44.6 SO: Okay, so, in many cases, the timing or the pattern of information or data, and in this case, what we're gonna talk about, investment returns, it really matters. And this, certainly truly comes to your money. So, like all of our topics, some general information here, definitely seek your own advice and do your own research. But we've talked many times about investing in markets, stock markets for your owning a fractional interest in companies, bond markets for your lending to governments, corporations, real estate, and different types of assets, and why does someone do that? They're trying to get an attractive long-term return. But in almost all those types of assets, money doesn't grow in a straight line. There's gonna be good years that are up, there's down years that are bad. Ideally, we're picking something that overall the good years, vastly outweigh the bad years.

0:01:31.6 SO: But that good news or bad news first can make a big difference in some cases. So, CJ, if you have a lump sum and you invest it, let's say you have $1000 and you put it in and you invest it for 10 years, the pattern of returns doesn't matter whether it's good news or bad news first. If it's up 10%, down 5%, up 5%, down 10%, it doesn't matter. But it does make a big difference if you are systematically putting money in or systematically taking money out. So if you're accumulating, and instead of having a lump sum of a $1000 you're putting in $100 every year for 10 years, it can actually work to your advantage. They have the bad news first, they have down years first, you're buying more volume and you're buying cheaply, and then you get the big returns later when you have more money in the market.

0:02:21.4 SO: So, that's a good thing, and that's a good thing to keep in mind for younger investors who are putting money in the retirement plan. If they go, oftentimes they can get discouraged thinking, "Oh, it's all stacked against me. Things are terrible. I put some initial money and I don't have that much money, and it went down." Keeping that long view and knowing that it can actually work to your advantage. The important thing is just consistently keep putting dollars in over the long haul. So that's good news. But here's the real catch, and this is the thing I kind of wanted to focus on this morning CJ, for folks who are at retirement or planning for retirement, it's on the horizon, the accumulation is the term, kind of a weird term that we like to use in the finance world that's come up.

0:03:01.0 SO: The idea that you have a lump sum of the money, which you've invested and put away, and you're gonna be taking it out periodically over time. This pattern of returns, it makes a big, big deal. And if you have bad returns early in your retirement, that's what we call a sequence of return risk. Meaning you might have to sell more investments at lower prices early in retirement. It can deplete that pool of assets much quicker than you want it to. And we just went through, 2022. This is a great example CJ. It was a bad year for stocks. It was a historically bad year for bonds, which are usually regarded as the safe asset, and it had very high inflation, which is pushing up people's cost of living. So it's kind of a double whammy. It would've been a tough year to have that early in someone's retirement. That's what this like concept of sequence of return risk is.

0:03:52.6 CJ: Okay. So, all right, that's kind of tricky stuff, but what can we do about it?

0:03:57.7 SO: Yeah, right. What's the meat of it? What can we do about it? There's a few things that I suggest people look at. You can't control the pattern of returns. You can't control the markets, but we can work to control your exposure to it. So how much is in the market, what types of holdings you have and your asset allocation, the mix of stocks and bonds, the types of stocks and bonds, that's critical. So having a well-designed portfolio can make a big difference, appropriate blend makes a big, big difference, that can not control the returns, but it can manage your exposure, manage the volatility. That makes a big difference. Adjusting that portfolio over time. There are some funds people can buy that are called target-date funds or retirement income funds, where this is done inside of the fund in what's called a glide path, where it adjusts to more conservative investments along the timeline when you might need those funds.

0:04:54.5 SO: And rebalancing. So that's a big one. Some people turn towards tactics that try and just provide a level smooth return instead of being exposed more volatility, maybe they invest in real estate that's essentially paid off. So it's just getting checks in the mail every month, as long as you don't have maintenance and tenant problems and vacancies and things like that. Or annuities, which is an insurance product essentially, where you're buying a pension, it can provide that stable stream of income. I would, certainly... Both those types of strategies make sense in some cases, but they also have their drawbacks and downfalls. If you haven't necessarily set yourself up to prepare for the volatility, you might wanna take a serious look at just reducing spending in those down years, which is not a fun idea.

0:05:46.0 SO: But what I've found is many people that's intuitive and it feels better. They know their portfolio's down. They know it's a bad year, they want to cut back. They want to do something that feels proactive. So there's a couple of ideas, but one big one CJ, that this is the approach that I really advocate and work with people on is you're in canoe country. I love wilderness canoeing. I'm a canoe guide. I love the boundary waters. I really love going on wilderness river trips where there's a bit of white water. I'm heading to Northern Maine in a week to do a long river trip, and that's exciting. But there's this saying with wilderness canoeist, and the saying is, "No one ever died on the Portage Trail."

0:06:26.4 SO: So, in the boundary waters, we portage going from lake to lake. But if you're going down a river and there's white water and maybe it's above your level or there's a serious drop or there's some falls, no one ever drowned on the Portage Trail. And sometimes it makes sense to just get out of the canoe and hike around that hazard and you can do that in a sense in your portfolio by building a short-term bucket of safer type investments to insulate yourself from the market risk. And the idea being when those bad years come in the stock market, which we know they come along every three to five years, it's part of the price you pay to get those nice very high long-term returns. Have a portage trail so to speak in your portfolio of safer short-term holdings in the security bucket that you can draw on while you let the market go through its gyrations, go through its bad period and then go on to reach new heights that it has in the past.

0:07:22.4 CJ: So, what kind of holdings though would you put into a short-term bucket to help manage this sequence of return risk?

0:07:30.5 SO: Yeah, great question, CJ. What we'd be looking for is things that are relatively stable ones that would typically be considered safer assets that just makes sense. So cash from the bank, certificates of deposit of bank, money market funds. We've recently had issues with the bank scare, so pay attention to FDIC limits and your liquidity and your ability to access those funds. But that might be your very first line of defense or building yourself a portage trail that you can use in those really turbulent situations. And then stepping up beyond that, things that offer a bit higher return but you might be taking on a bit more volatility would be bond or fixed income-type holdings. Borrowers with strong credit worthiness, short-term bonds of high quality. And here's the great news CJ, for the first time in like 10 years, you can actually get a really nice rate of return on these types of holdings in your safety bucket. With the interest rates higher, it's a completely different environment than it's been for a long time. So you can have that security built into your portfolio to help manage the sequence of return risk and let you get off the river of things like dice.

0:08:47.3 CJ: I like that idea. I'm a kind of a belt and suspenders girl myself. So all right. Anything else we should know about this sequence of return risk and what we can do about it?

0:08:58.4 SO: Well, so what I was talking about the idea of having this short-term bucket, you'll hear people reference the bucket strategy in retirement, that's a very common term. It's an interesting concept. The more analytical term is liability-driven investing. I do have a blog post where I wrote fairly extensively about what's good about this approach and also what you need to be aware of or what some of the downfalls are. But I think it's definitely worth considering. And again recommend people do their research, consult with an expert and really think through, prepare for the next time there's a bad downturn. See, 2022 was a rough year and you wanna be prepared for future events like that.

0:09:42.1 CJ: Indeed.

0:09:45.4 SO: Like decumulation phase.

0:09:45.5 CJ: All right. Scott, thank you so much. There's a lot to think about in that. And we'll put this interview up on our website.

0:09:52.5 SO: Great. Thanks, CJ.

0:09:53.6 CJ: Thank you.