Clients facing retirement find themselves making investment decisions that will determine their financial security for decades. And the cost of getting off to a poor start can be disastrous.
That’s because losses that occur early in retirement have a much greater impact than those suffered later. It doesn’t matter if everything averages out in the end, as low returns at the outset may leave little or no money remaining when things do improve.
What’s worse, the damage increases dramatically when clients are simultaneously draining their portfolio by making regular withdrawals.
Analysts refer to this as “sequence of returns” risk. However, in a recent paper entitled Sequence-of-Return Risk: Gorilla or Boogeyman? published in the Journal of Financial Planning, Jonathan Guyton, a financial planner in Minnesota, suggests that such concerns may be overstated.
For someone who retired in 2000 with a globally diversified portfolio that included an allocation of 60% stocks – despite two market crashes in the first several years – things aren’t going too badly at all. But that doesn’t mean the results couldn’t be improved.
To illustrate, the paper uses a portfolio with a starting value $1.2 million. Thirteen years later, the portfolio, which started with $48,000 of withdrawals (a 4% withdrawal rate), still is at $1.1 million; and with inflation adjustments, the withdrawals have increased to about $66,000, resulting in a current withdrawal rate of roughly 6.1%.
For a healthier financial situation, however, Guyton’s paper argues, financial advisors should adopt a more dynamic approach to guide ongoing decisions about asset allocation and the distribution amount. The idea is to create “guardrails” that will keep a portfolio on track if withdrawal rates get too high or if markets dip too low. For example, when markets are sufficiently overvalued or undervalued, the paper suggests modifying the stock allocation to 50% when overvalued or to 80% when undervalued.
The paper also recommends that clients forgo inflation adjustments in years following negative returns or even trim withdrawals by up to 10% after big declines, such as in 2008.
The results of implementing both dynamic policies simultaneously are striking. So much so, the paper says, that employing them together would add about 100 basis points to the sustainable withdrawal rate compared with that available under static policies.
Under the actual return sequence, a retiree in year 2000 begins her 14th year of distributions with a 9% larger nest egg than when she retired. Her next year’s withdrawal amount following the inflationary increase will be 5% of the portfolio’s value. Under the dynamic withdrawal policies, she previously had one inflation freeze after 2001 and two cuts to spendable income (after 2002 and 2008).
Compared with a static strategy with an initial 4% withdrawal rate, the dynamic approach supported both higher total cash flows for spending as well as a larger remaining portfolio balance.
Not only can this dynamic approach foster the mid-course adjustments occasionally required for sustainability, the paper concludes, it can go a long way in blunting the impact of those economic circumstances that lie beyond the control of both client and advisor.
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