Don't Let Sequential Risk Ruin Retirement Plans

Retirement planning can be a stressful time for many Baby Boomers because there are so many questions that cannot be answered. How long will I live? What will my health be like in 20 years? Will my spouse or I need long-term care? And the elephant in the room: How much money do I need?

Scientific advances in the medical community have made it not only possible but likely that a healthy retiree in their 60s could live well into their 90s. While it’s great that retirees are living longer, healthier and more active lifestyles than ever, on the flip side of the coin, there is a vast amount of time their retirement savings must last. Pulling funds out of a portfolio for 30-plus years creates tremendous strain on the portfolio.

To further compound things, factors such as the retiree’s age, withdrawal rate and current market conditions have a paramount impact on the longevity of the portfolio. Perhaps most frightening even a modest loss in the early stages retirement, regardless of the size of an investment portfolio, can derail an otherwise solid investment plan leaving a retiree in a precarious position. (For related reading, see: How Can You Make the Most of Your 401(k)?)

Sequential Risk in Retirement

Sequential risk is not a term that is used in everyday conversation. However, anyone who has recently retired or has retirement on the horizon should make sure they have a basic understanding of the concept. In essence, sequential risk is the notion of making withdrawals from an investment portfolio during or immediately after periods of poor performance. A retiree who begins taking withdrawals from their portfolio following a market downturn is at a much higher risk to deplete their portfolio. To demonstrate the magnitude of sequential risk let’s look at two similar scenarios with drastically different endings.

Examples of Sequential Risk in Retirement

John and Lisa have accumulated a million dollars and decide to retire at age 65. They determine that they will need $90,000 to live on of which $25,000 will come in the form of Social Security and the remaining $65,000 will be withdrawn from their portfolio annually (adjusted for inflation). Unfortunately for John and Lisa, during the first year of their retirement the market falls and has a 20% loss. In years two through 14 their luck changes and the market remains stable returning 7% annually. In year 15 they are hit with even more luck as the market surges and they receive a 30% return on their investment.

The good news for John and Lisa is that they’ve had a healthy and active retirement and maintained their same standard of living for the last 15 years. The bad news is at age 81 they can no longer support themselves financially because they have less than $25,000 remaining in their portfolio. To make matters worse, the recent financial stress has caused John and Lisa’s health to take a turn for the worse and now they are considering moving into a state subsidized nursing home. (For more, see: Tips for Baby Boomers Who Are Ready to Retire.)

John and Lisa’s neighbors, Bruce and Diane, have also accumulated a million dollars and decide to retire at age 65. They too will need $90,000 in living expenses and will receive $25,000 from Social Security. Fortunately for Bruce and Diane, in their first year of retirement the market spikes and returns 30%. In years two through 14 the market remains unprecedentedly stable and returns 7% annually. Unfortunately, in year 15 their string of good luck changes and the market drops 20%.

Fortunately for Bruce and Diane, due to the positive early returns, their portfolio was large enough to withstand the latest market downturn. Despite losing over $229,000 in their portfolio over the last year, they still have over $900,000 dollars remaining. Like John and Lisa, Bruce and Diane have lived a healthy and active retirement. However, instead of looking for nursing homes, Bruce and Diane are looking at independent living villas in Costa Rica because the winters in Florida are just too cold for them.

While the facts remain strikingly similar, the end of their stories is vastly different. Unfortunately, no one can predict what the stock market is going to do tomorrow, let alone in the next month, year or 10 years from now. Unless you have a flux capacitor, trying to plan your retirement date around future market forecasts is a futile and will not get you far. So what can be done to mitigate sequential risk? (For more from this author, see: 3 Easy Ways to Save Big on Life Insurance.)

Mitigating Sequential Risk in Your Future

There are a multitude of different strategies that work well to help reduce the risk associated with early retirement withdrawals. Regardless of the specific strategy chosen, they all centrally revolve around two main concepts – minimizing volatility and monitoring withdrawal rates. Strategies that focus on minimizing volatility may be a more appropriate approach as changing your withdrawal rate in retirement is not feasible for many retirees, especially for those living on a fixed income.

Rather than taking a traditional approach of starting at 60% stocks (40% bonds) and reducing the weight as you age, consider taking a road less traveled. In order to minimize volatility during the onset of retirement, switch to an ultra-conservative portfolio. Dropping to a 30% stock allocation in early retirement has historically kept losses, even during the worst bear markets, to single digits. Minimizing the effects of market crashes protects your nest egg during the most critical stage of your retirement. As you get further along into retirement, gradually increase your equity exposure to as much as 60%.

Another hybrid approach to minimize an early retiree’s volatility involves creating a dedicated cash flow stream to fund withdrawals. Using this approach, the amount of the withdrawal would be the same. However, a dedicated portion of the portfolio would be specifically set aside to fund the withdrawals. The simplest approach to create a dedicated cash flow stream is through the use of a laddered certificate of deposit (CD). A ladder is a sequential series of maturing term CDs – purchasing a 12-month, 24-month, 36-month, 48-month and 60-month CD, for example. The maturing CDs give a retiree a guaranteed cash flow without having to worry about current market conditions because the portion subject to withdrawals has already been pre-funded and cannot lose value. The volatility in the remaining portion of their portfolio is mitigated because no funds are being withdrawn from this portion.

Both approaches are based on the fundamental philosophy that an early retiree is at a greater risk from a market downturn than a mature retiree due to the number of withdrawal years. Consider reducing your sequential risk by transitioning to a more conservative portfolio at the onset of retirement or by creating a dedicated cash flow stream to eliminate or minimize early withdrawals from your portfolio. (For more, see: 10 Habits of the Healthy, Wealthy & Wise.)