If you’ve read our previous articles, you know the Paraclete Wealth Management team believes strongly in the power of financial education. Our mission with today’s topic is to educate you about several very real risks threatening to undermine your retirement security. Of course, we also want to empower you now, in the present, to take control of your financial future. Below, we share more content from Power of Zero guru David McKnight about a threat lurking in your portfolio – sequence-of-return risk – and the risk multiplier that makes it even more dangerous. As you read, take notes on questions you may have and please feel free to reach out to us to schedule a discussion.
Understanding Sequence-of-Return Risk
If you’ve never heard of sequence-of-return risk, you’ll want to get familiar with it now. It’s one of the reasons people run out of money in retirement – which is exactly what I want to help you avoid.
Perhaps the simplest definition is the danger that the timing of your retirement portfolio withdrawals will have a negative impact on your overall rate of return over time. For example, withdrawals during a bear market are much more damaging to your financial security than the exact same withdrawals in a bull market.
The Urgency of Creating a Plan to Combat Sequence-of-Return Risk
I want to help you purge your retirement plan of the dangers associated with sequence-of-return risk. To set the table for our discussion, let me describe a scenario that plays out all too often in financial advisory offices across the country:
Jack and Julie Harrison step into their new financial advisor’s office, atwitter at the prospect of beginning what they hope will be a thirty-year period of permanent, willful unemployment – the retirement they’ve worked hard to enjoy. Now, they’re ready for the big payoff. They can hardly wait to see the results of their advisor’s analysis of their retirement picture.
After a few minutes of small talk, the advisor triumphantly pushes a retirement projection across the table. The Harrisons pick it up and begin to pore over it. According to the advisor’s calculations, they can draw $65,000 per year from their $1 million IRA every year for 30 years. And all they have to do is average 8 percent growth per year. Piece of cake, the Harrisons think to themselves. The market has averaged 8 percent per year over the previous 30 years, so why should the next 30 years be any different? Moreover, coupled with their Social Security, that $65,000 completely covers their lifestyle needs. Boom! Permanent willful unemployment, here we come! After a few moments of unrestrained euphoria, their eyes home in on the massive number at the bottom of the page. It’s the amount they’ll have left over by age 95. It’s over $2 million! Their eyes nearly pop out of their sockets.
But the financial advisor isn’t done. He slides a second projection across the table, scarcely able to contain his enthusiasm. If the Harrisons don’t want to leave more than $2 million to the next generation, he explains, they could spend $82,500 per year and bounce the check to the undertaker at age 95.
As the Harrisons look over the projection, visions of cruises, daily rounds of golf, and doting on cherubic grandchildren in far-flung cities dance in their heads. They can hardly believe it. For all their retirement dreams to become reality, all they have to do is average 8 percent growth per year. As they take in the row of numbers, they both smile broadly. Could it be this simple?
Truth: Retirement Security is Never Simple
The answer, of course, is that a successful retirement is never as simple as this above scenario. What this financial advisor’s projections failed to account for is the real-world nature of stock market returns. Average rates of return can be a meaningful metric in the years leading up to retirement, but they lose all significance the very moment you begin taking distributions from your stock market portfolio. Once distributions begin, the sequence in which those returns are experienced tells a whole different story. In other words, when you begin withdrawing money, the rules of the game change dramatically.
To illustrate the importance of sequence-of-return risk in retirement, consider the story of two couples, the Johnsons and the Browns. Both couples start with a $1 million nest egg when they retire at age 65. Both couples take annual $50,000 distributions, with 3 percent annual adjustments for inflation.
Throughout their 30- year retirements, both couples average a 6.5 percent return on their stock market portfolios. The Johnsons, however, experience a cluster of negative returns early in retirement, while the Browns experience their negative returns much closer to the end.
Even though both couples achieve the same average rate of return, the Johnsons run out of money in year fifteen! Why? Because the combination of withdrawals and negative returns early in their retirement years killed off the worker dollars required to sustain their inflation-adjusted lifestyle expenses over time. The lethal combination of retirement withdrawals and stock market losses sent their portfolio into a death spiral from which it never recovered. As a result, the Johnsons must endure fifteen years of bare-bones, subsistence-type living, eking out an existence on Social Security alone.
Now, if the Johnsons live for only fifteen years, then the impact of sequence-of-return risk is effectively neutralized. Sure, maybe their children won’t receive the inheritance they were hoping for, but the Johnsons won’t have to endure fifteen years of poverty.
But living a much shorter life is hardly a reasonable (or motivating) solution for mitigating sequence-of-return risk. Given the choice, the Johnsons would much prefer living to a ripe old age and never running out of money.
The ‘Risk Multiplier’ making Sequence-of-Return Risk Even More Dangerous
Are you beginning to see the fraught relationship between sequence-of-return risk and longevity risk? The longer you live, the more devastating the consequences could be, should a sequence of negative returns strike a lethal blow to your stock market portfolio in your early retirement years. It’s a scenario I would very much like to help you avoid.
If you’re interested in learning more about sequence-of-return risk and how longevity risk can multiply the danger to your retirement security, please reach out to schedule a complimentary strategy session today. At Paraclete Wealth Management, we’re committed to helping our clients build retirement plans that take into account all the risks lurking ahead so you can keep more of what’s yours and retire with peace of mind. Ready to get started? Reach out today!
