The recent market volatility has reminded all of us of an important consideration when an investment portfolio is being used to support living and other expenses in retirement. This important consideration is called “sequence of return” risk. Sequence of returns is simply the order in which the annual returns of your portfolio occurs. Sequence of returns have only marginal impact on the performance of a portfolio over a long period during the accumulation phase. However, in retirement, sequence matters. Two individuals, with the same withdrawal needs and average rates of return over their lifetimes, can have very different results depending on when the good and bad investment return years occur. Stated simply, we want good returns early in our retirement, and can accept lower returns later in retirement.
Since we cannot always control the timing of portfolio withdrawals, and certainly cannot control the timing of market returns, how do we mitigate sequence of return risk?
A sound retirement income plan must include sequence of return risk analysis. That is, projecting retirement income with a simple average rate of return is not sufficient. At Ancora, we “stress test” multiple scenarios for every retirement plan using tools such as bad timing analysis, bear market safety margin analysis, and Monte Carlo analysis. All of these tools help us understand how sequence of return risk can impact a client’s plan. These tools also help us design an asset allocation that provides the appropriate level of risk and return to meet the client’s specific spending needs.
Use a Cash Reserve
A sound cash reserve, three to six months or more of spending needs, can alleviate the pressure to sell into declining markets. The cash reserve can be spent down, and then replenished when market returns are more satisfactory.
Portfolio diversification, including stocks, bonds and alternative, low or negatively correlated assets, can minimize sequence of returns risk. With proper diversification, we can avoid selling underperforming asset classes to fund spending, helping to maintain the long-term prospects of the portfolio.
Develop an Income Stream
Income producing assets, such as high dividend paying stocks, can help reduce the need to rely on capital appreciation to fund spending.
Maintain Spending Flexibility
The most successful retirement plans are the ones with spending flexibility. If spending needs have a large fixed component, it is often not possible to avoid ill-timed drawdowns of the portfolio. However, the long-term success of a retirement plan can be significantly improved if discretionary spending can be deferred following years of poor market returns.
Please contact your Ancora advisor if you would like more information about our Lifetime Planning process, including retirement income planning.