by Dave Kutcher
The “sequence of returns” risk is a concern for investors, particularly if you are withdrawing from your investments, such as when you begin your retirement. It refers to the order in which your returns on a portfolio are received. Negative sequence risk occurs when negative or lackluster returns happen early in your withdrawal period, which can significantly reduce the longevity of your portfolio.
With people living longer and longer, coupled with the rising cost of health care, this can be a devastating occurrence. All hope is not lost, however, if you plan correctly and utilize financial solutions that are purposeful in mitigating this risk.
Key Points:
1. Impact of Negative Sequence of Returns:
• Early Losses: If you experience negative returns early on while simultaneously withdrawing funds, your portfolio shrinks faster, leaving you with less capital to benefit from potential future gains.
• Recovery Difficulty: Recovering from losses becomes more challenging because you have fewer assets left invested and you do not have time on your side.
2. Mitigating the Risk:
• Diversification: Spread investments across different asset classes (stocks, bonds, real estate, annuities, cash value life insurance) to minimize risks.
• Asset Allocation Adjustments: Adjust asset allocation based on market conditions and personal circumstances.
• Emergency Fund: Maintain a sufficiently large emergency fund or a separate cash reserve to cover expenses without needing to sell investments during market downturns. (You must plan early for this … don’t wait until retirement or you will have far less to choose from as financial tools to help correct this risk)
• Flexible Withdrawals: Be flexible with withdrawal amounts. Reduce withdrawals during years when the market is down. (You must have financial assets in the right place to do this)
• Income-Producing Investments: Invest in assets that provide steady income (like dividends, interest) to reduce the need to sell investments during downturns.
• Annuities: Consider annuities to provide guaranteed income, reducing reliance on portfolio withdrawals.
• Professional Advice: Seek advice from financial advisors to tailor strategies specific to your needs.
By understanding and preparing for the sequence of returns risk, you can better protect your investment portfolio, especially during the crucial retirement years.
The goal here is to create a way to counteract negative investment performance during your distribution phase of your financial life … otherwise known as retirement. It is best dealt with prior to retirement if you want more options to be in play for you when you need them. Waiting until you begin your retirement means you will have far less options available to you because you don’t have time to accumulate assets in a way that helps protect you from this negative sequence risk.
Having a bucket of money that is not correlated to the stock market—often called a “cash reserve” or “safe bucket”—is a strategic way to provide investment safety during retirement, particularly in the context of negative sequence of return risk. Here’s how this approach can help:
Key Points:
1. Protection During Market Downturn:
– In the event of a negative market, your primary retirement plan, assuming invested in an asset allocated portfolio of stocks and bonds, performs poorly. Having a separate reserve of stable assets, not correlated to the market, allows you to avoid withdrawing from investments at a loss.
2. Liquidity and Stability:
– A cash reserve provides liquidity and ensures that you have readily accessible funds to cover your living expenses without needing to sell assets from your investment portfolio at depressed prices.
3. Reduced Market Exposure:
– By having money in assets that are not correlated with the stock market (e.g., cash, money market funds, short-term bonds, fixed annuities and fixed cash value life insurance), you reduce your overall market exposure during volatile periods.
4. Flexibility:
– The presence of a non-correlated bucket allows you to exercise flexibility in terms of which assets to withdraw from, enabling you to time the market better and mitigate losses. The big picture is two-fold; being able to be flexible as to your income needs as well as having the financial resources in place to provide choices for yourself as to where you take money from during retirement, depending upon what outside influences are impacting your retirement assets.
5. Peace of Mind:
– Knowing that you have a reserve can provide peace of mind and reduce anxiety during market downturns, allowing for a more disciplined investment strategy without panic selling. Fixed rate, guaranteed income products provide similar peace of mind.
Implementing a Non-Correlated Bucket Strategy:
1. Initial Allocation:
– Determine a portion of your retirement portfolio that should be allocated to non-correlated assets. This amount can vary but commonly ranges from 2 to 5 years’ worth of living expenses. The more money you have in a non-correlated bucket, not only provides for flexibility as to where you withdraw your funds during poor market performance times, it also significantly increases the rate at which you can distribute funds to yourself, allowing you to reap higher income benefits without increasing risk of running out of money later in your life. Being able to increase your annual rate of distribution to yourself also helps solve the problem of not having accumulated enough money by retirement age to provide an income sufficient to meet your needs at traditional distribution rates, typically around 3%.
2. Types of Non-Correlated Assets:
– Cash: The most liquid form, providing immediate access to funds. While this is a valid bucket, you will find it difficult for the rate of return on these funds to keep up with your goals.
-Money Market Accounts: Slightly higher yield than cash while maintaining liquidity. This option provides a lot of flexibility, slightly higher returns than simply cash.
– Short-term Bonds: Lower volatility compared to longer-term bonds, offering more stability.
– Certificates of Deposit (CDs): Longer-term CDs can offer a better return than cash or money markets, though with early withdrawal penalties.
– Fixed Annuities: Fixed annuities offer opportunities for gaining higher return, but will have some liquidity rules you will need to understand and be sure they fit with your planning and timing.
– Fixed Cash Value Life Insurance (Not to be confused with Variable Life Insurance): Over time, cash value life insurance should generate returns like long term bonds. If acquired early enough in your pre-retirement years your values will provide a strong opportunity to mitigate negative sequence of return, avoid income taxes on the growth within the policy itself, provide options for taking money out tax-free and also provide a safety net to your partner in life that, should you die prematurely, the life insurance element of the policy will help fill any gap in your savings preparing for retirement via the death benefit, which will always be higher than the cash value in the plan and I is paid income tax-free to your beneficiary.
3. Replenishing the Reserve:
– During times of market growth, consider taking a portion of the gains from your portfolio to replenish or increase your non-correlated bucket.
4.Regular Review of your Assets:
– Periodically review and adjust the size of your cash reserve based on changes in your living expenses, interest rates, inflation, and overall market conditions.
By integrating a non-correlated bucket into your retirement strategy, you build a buffer against negative sequence of return risk, ensuring that your retirement years are financially secure and less vulnerable to the unpredictable nature of market fluctuations. Choices, choices, choices … flexibility, flexibility, flexibility. Don’t pin yourself into a corner with few choices and little chance of making changes as economies and markets change year to year.
My name is David A. Kutcher, a retired Marine Corp Captain. My business partner in the lower 48 is Richard C. Scott, CLU, LUTCF. For nearly 40 years we have been helping folks with their personal retirement decisions. You can catch us on the radio every Saturday morning, “Retirement in the Last Frontier”, 8:30-9:30 on AM 650, Keni Radio and on Tuesday mornings, KFQD News Talk Radio AM 750 and FM 103.7. Frontier Retirement, 10928 Eagle River Road; Eagle River, AK 99577; (907) 795-7452.
