Sequence-of-return risk hurts more than just recent retirees

The conventional view of sequence-of-return risk is that it’s something retirees face as they take ongoing distributions from a retirement portfolio, and requires caution in the early years of retirement.

(Michael Kitces)

Yet the reality is that sequence-of-return risk is equally relevant for accumulators in the years leading up to retirement, as well. The only difference is the problematic sequence is reversed – for retirees, the dangerous sequence is to get bad returns at the beginning (of retirement), while for accumulators it’s getting bad returns at the end (of the accumulation phase).

In fact, the volatility of an accumulator’s portfolio can also be viewed as its retirement date risk – the danger that a planned date of retirement (or financial independence) may turn out to be later than originally expected, due to a poorly timed sequence of bad market returns. And as it turns out, the greater the volatility of the portfolio and reliance on growth, the greater the retirement date risk that goes along with it.

Accumulators who are in their final years of earning before retirement may wish to manage risk and reduce the volatility of the portfolio. Of course, making a portfolio more conservative at the end of the accumulation phase may force a saver to work longer, or save more, to cover the lower expected returns in those last few years. For those who don’t want the risk of a later retirement date, a decreasing equity glidepath, or more conservative asset allocation strategy, en route to retirement may be an appealing strategy.

THE RISK OF RETURNS

Sequence-of-return risk is not unique to retirees taking money from a portfolio. The concept also applies to accumulators who are still contributing to a portfolio as well.
For instance, imagine an investor whose goal is to accumulate $1,000,000 by saving $300/month every month starting at age 25. Assuming an 8% long-term rate of return on a balanced 60/40 portfolio, this systematic savings strategy would be able to accumulate a $1 million portfolio balance by age 65, after 40 years of compound savings.

The projected accumulation, though, doesn’t assume the portfolio gets a long-term average return of 8%, but that it generates a return of exactly 8% each year. Just as any deviations from that return assumption can dramatically impact the sustainability of retirement distributions from a portfolio (a sequence-of-return risk), so can it adversely impact the projected accumulation of a retirement portfolio with ongoing contributions.

For instance, a 60/40 portfolio has a long-term standard deviation of about 12% per year, or about 3.8% each decade. (The standard deviation declines by the square root of the number of years.) Given that 95% of returns are expected to fall within two standard deviations, plus or minus, this means that an average return of 8% would actually have a 95% chance in any decade of falling somewhere between 0.4% and 15.6% per year, compounded across the 10-year time window.

BLACK SWANS AFLOAT

What happens if in the first decade, a saver experiences a -2 standard deviation event, but in the last decade of work before retirement she recovers with a +2 standard deviation bull market? What if the favorable bull market happens at the beginning, and the -2 standard deviation mediocre decade comes at the end? (These would not be “black swan” events, but merely mediocre returns that could potentially be dangerous.)

As the results show, the sequence of return has a dramatic impact. In both of the scenarios, long-term returns are exactly the same. Both accumulators averaged out to the same long-term returns of 8%. The difference is simply that one saw fat returns early when few contributions had been made to the portfolio, and then saw bad market returns later that affected the bulk of the savings. The other saver had bad returns early on when there wasn’t much in savings, and enjoyed good returns at the end when most of the contributions had been made.

For someone working towards retirement, the difference is significant. In the best situation, the accumulator with the plan to retire at 65 with $1 million reaches the goal by age 62. The accumulator with the bad returns is still 34% short of the $1 million goal at age 65. Even if returns subsequently revert back to 8%, that saver will have to wait until age 70 to reach the original $1 million goal. Of course, a severe bear market in the final year or two before retirement could worsen the situation.

RETIREMENT DATE RISK

Portfolio volatility doesn’t just impact the value of the amount saved, but the timing of retirement itself. Viewed another way, portfolio volatility for an accumulator creates retirement date risk.

The goal of retirement typically has two components: a target dollar amount to cover retirement spending, and a target date by which that amount will be accumulated, allowing the saver to stop working. If the accumulator can’t achieve one part, the other must be adjusted.

When a saver is forced to retire early – perhaps because of ill health – the retirement date becomes unchangeable. Spending must be adjusted – often downwards – to accommodate the changed plans.

A volatile portfolio kept during an ill-timed bear market can force an accumulator to work longer as he waits until the portfolio recovers. The more he relies on growth, the more sensitive becomes the outcome to volatility and the greater potential that he’ll miss his retirement date target.

MANAGING THE RISK

How can a prospective retiree manage his exposure to retirement date risk?

First, recognize that in the final decade before retirement the volatility of the portfolio and its returns matter. The ongoing savings contributions no longer drive the outcome. The reason, simply put, is that as a portfolio compounds, the relative impact of contributions grows less.
In the first year of saving, setting aside $300 a month leaves a saver with $3,600 in the first year. In the second year, if the portfolio earns its expected 8%, it would add just $288 to the account, less than a one-month contribution.

By the last decade, however, return on the investment portfolio increases in value and new contributions become trivialized. In the last year, as the portfolio grows from nearly $925,000 up to the final $1 million target, growth contributes almost $75,000, dwarfing the $3,600 of final contributions. In the final year, one month’s growth is nearly double one year’s savings.
anaging retirement date risk, then, centers on managing the volatility of the portfolio itself and not necessarily the contributions to it. The exception is that a lower-volatility portfolio with a lower growth rate may require larger contributions to meet the retirement goal.

DECREASING EXPOSURE

The easiest way to reduce retirement date risk in the final years is to reduce portfolio volatility in those final years. Retirement date risk can be reduced by decreasing exposure to volatile assets (for example, equities) in the years before the target retirement date.

Read more: Top performers: Target-date funds 2030 - 2035 Target date funds, or lifecycle funds, which typically take equity exposure off the table in the years before retirement are a good bet when it comes to asset allocation for accumulators. Reducing equity exposure in the final years – as the portfolio is largest and most sensitive to volatility return – is an excellent way to lower retirement date risk.

Assume that the saver of $300 each month into a 60/40 portfolio begins to take equity exposure down by 3% a year in the final decade before retirement. Each 3% equity reduction will shrink the expected return by about .15% from the original 8%, and the standard deviation by about 0.5% from the original 12%.

Implementing this decreasing equity glidepath in the final accumulation years significantly reduces retirement date risk, shrinking it from an eight-year window to one of just six years! The “early” retirement scenario for good returns begins at age 63, but the bad return scenario delays it to age 69.

On the other hand, the shrunken returns associated with being more conservative delays the retirement date slightly – from age 65 to age 66. For most accumulators, this is probably an acceptable trade-off.

The prospective retiree could also try to ramp up savings in the final decade to help make up the difference – an increase in the monthly savings rate from $300 a month to $415 monthly in the last decade would bring the retirement time to the original age 65, even with the decreasing equity exposure in the final years. (The increasing savings requirement is material, boosting savings by 40%. Because the portfolio is so large, even moderate shifts in returns have an outsized impact on the final amount.)

Ultimately, investors who have no cash flowing out or into a portfolio can wait for long-term returns to bloom. For retirees taking distributions, or people making contributions, the cash flows moving in and out introduce a sequence-of-return risk, which compounds for savers relying on long-term returns to compound to meet a retirement target. The greater the portfolio volatility, the greater chance they’ll miss their retirement target.

Portfolio volatility is not merely a risk to be waited out through several adverse market returns. Advisers should proactively manage it.

This article originally appeared on Kitces.com.
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