How To Mitigate Sequence Of Returns Risk
One of the best-kept financial advice secrets about retirement planning is the importance of thinking long-term when it comes to managing your retirement funds, specifically risks like “sequence of returns”. As you take out money from your retirement portfolio, your sequence of annual returns -whether positive or negative- will affect your assets and how long they last.
In the year 2011, the U.S. Government Accountability Office (GAO) published a report that surveyed the impact of certain risks like the sequence of returns, which are associated with various forms of retirement income.
The report utilized two unique annual rate sequences to demonstrate how the sequence of returns works as a risk, and how it could theoretically affect a portfolio of investments.
Sequence 1 – UP 7%, UP 27%, DOWN 13%
As you can see, the rule of thumb shown in this sequence of returns is that you’d end up with the same annual rate regardless of how you experience returns while taking income out of these returns will greatly affect the sequence of returns. For example, if the returns in your portfolio repeat the same pattern of 7% to 27% and then down to 13% throughout your retirement, and then you decide to withdraw an annual income of 9% of what’s contained in the portfolio, you’ll benefit from your assets for 24 years.
Sequence 2 – UP 7%, DOWN 13%, UP 27%
As illustrated in the above example, your average rate would turn out as 7% regardless of the sequence of returns in which you experience the returns in your portfolio. So, if for example, your returns were to repeat a sequence of returns of 7% to 13% and up to 27% throughout your retirement, and you decided to withdraw an annual income of 9% each year, you’d only benefit from your assets for 18 years.
Although each of the circumstances described above averaged the same rate of returns, they both ended up with a different sequence of returns. That’s because the initial returns of the second sequence of returns appeared negative from the beginning, which left lasting negative repercussions on the lifecycle of the assets.
What is Sequence of Returns Risk?
The term ‘sequence of returns risk’ can also be referred to as ‘sequence of returns risk’, and it tends to negatively affect your assets as you continue to withdraw from your funds. The sequence of returns are followed by annual investment returns can be a major source of worry for retirees that are currently living off revenue from their investments.
Their concern is that the more they make withdrawals from their investment, the lower their returns will become. Factors like the time at which the returns are withdrawn, the long-term average of the returns, and the way in which an individual begins their retirement days can also affect their financial outcomes. Of course, the investor can’t control external issues like the state of the market, but they can take certain actions to limit the risk of getting negative returns in the long run.
How to Manage Sequence of Returns Risk
Your first line of defense in managing sequence of returns risk during your retirement years is to avoid superfluous spending. Your best bet is to make sure that your spending habits are consistent and adjusted for inflation as much as possible.
When it comes to the complete returns investment portfolio, you must endeavor to aggressively allocate your assets to increase your prospect’s success if you so happen to spend more than what your bonds are capable of supporting. Therefore, you need to figure out how much you should spend in order to increase your chances of success. Ultimately, your spending must be conservative if outliving your assets is a concern for you, and have an aggressive investment portfolio.
Also, an aggressive investment strategy might motivate a concerned retiree to spend less than they would have if they were dependent on fixed income assets. However, past results have shown that there really is no ‘safe’ spending rate if you have an unstable investment portfolio, which renders the whole strategy of conservative spending/ aggressive portfolio completely futile.
Although the intention behind this approach is to decrease the sequence of returns risk, it can actually escalate your risk, which leaves consistent spending and selling off more shares as the only other viable solution to consider.
Maintain Spending Flexibility
The next option is to maintain an aggressive investment portfolio while allowing spending to be more flexible. You can still mitigate sequence of returns risk by decreasing your spending as your portfolio begins to decline so that you have enough funds left in the portfolio to still allow for good market recovery later.
If you follow the strategy of withdrawing the same percentage out of your remaining assets on an annual basis then you limit your chances of experiencing a sequence of returns risk. Similar to investing in a lump sum of assets, it won’t matter what sequence your returns take.
However, you want to pair this particular strategy with portfolio performance and pair it with flexible spending for best results.
Reduce Volatility To Decrease Sequence of Returns Risk
Another method that you can try to reduce your risk of experiencing a sequence of returns risk is to decrease the volatility of your portfolio. A non-volatile portfolio by definition does no generate a sequence of returns risk.
It’s definitely not a good idea to spend constantly if you have a volatile portfolio, and if you accept the risks associated with volatility, you should rather try to be more flexible with your spending and modify it as needed.
It is also possible to decrease the downside of volatility, and you can continue spending constantly if the risk has been removed from your portfolio. Risk-combining through assets like income annuities and holding fixed-income assets will assist in maintaining constant spending.
For example, an average defined-benefit pension system is able to reduce the impact of volatility on the income of retirees by finding methods of combining the sequence of returns risk across different birth cohorts, which ultimately decreases exposure.
The benefits received by the individuals are thus contingent on the contributions that they make to the system and not on whether or not the market performs well. As a result, some pensioners might get more or less than they would if they were investing individually. Defined-benefit pensions are a very distinct asset class that could prove valuable to a lot of investors, because pensions actually broaden sequence of returns over time, thus enabling them to accumulate income based on their average long-term returns.
There are other tactics that you can consider to decrease downside risk, like beginning your retirement with a lower equity allocation than that which is recommended, and then proceeding to increase the allocation of stock as time goes by.
Not only does this approach reduce exposure to stock market declines that often negatively affect retirement stock of early pensioners, but it also lessens the likelihood and scale of retirement failures. On the other hand, you can also manage asset allocation through the funded ratio approach, which holds that aggressive asset shares should only be distributed when there are sufficient assets to still maintain retirement spending goals.
Lastly, you may have to sacrifice possible upside by using financial derivatives to establish a baseline of how low your portfolio might possibly fall.
Buffer Assets – Avoid Selling at A Loss
Another method to use in managing sequence of returns risk is to make sure that you’ve got other assets besides your financial portfolio, that you can draw on whenever the market faces a decline.
That said, it is not advisable to associate the return on these assets with the financial portfolio, because as buffer assets, their role is to step in during those times when the portfolio is experiencing a downturn.
As part of this strategy, you would have a cash reserve in place that is not only capable of supporting your retirement expenses for up to three years but is completely separate from your portfolio. The only downside to this approach is that it will prevent you from seeing the returns that the cash reserve could have generated if they were invested. Admittedly, maintaining a cash reserve can put a strain on your investment portfolio, which is why new alternatives have been formulated in recent years.
One viable alternative is to open a line of credit and use a reverse mortgage as a backup. Another possible alternative is permanent life insurance policies, whose cash value you can utilize as a reserve as well.
Protecting Against Sequence of Returns Risk
There are several ways in which investors can protect their retirement aspects from sequence of returns risk, such as putting off retirement by working for longer and planning for the worst in terms of expected rates of returns. The more contributions you make to the retirement fund, the more you’ll be able to compensate for losses experienced during times of market declines while providing additional capital to continue growing your investment. Investors can also branch out to invest in stocks that carry less risk, but whose value can still fluctuate due to market changes.
Why Sequence of Returns Risk Matters
The sequence of returns can seriously influence the income available to you during your retirement years. While two different retirees may start out with the same level of wealth and the same long-term averages, they may end up with totally different outcomes financially due to the state of the economy at the beginning of their retirement
For instance, a retiree who begins their retirement years during the worst of a bear market, with most likely see a rise in value for the asses in their portfolio as the market recuperates. However, they’ll still end up with lower returns overall due to the amount that had to be deducted at the beginning of the retirement. The same retiree will still be withdrawing funds from their portfolio even as it continues to lose value, hence getting less in equities that may have benefited them with better takings in the long term.
On the contrary, someone who begins their retirement when the market is experiencing an upturn will receive higher returns from taking early withdrawals and their equities will be worth more. Essentially, there will be more equities in the portfolio of a bull market retiree than a bear market retiree, which enables the former to earn returns late into their retirement years, especially when the market experiences strong overall returns.
Contrarian Investing To Mitigate Sequence of Returns Risk
As the name implies, contrarian investing is based on the strategy of purchasing and selling right when investor confidence is low and the price is lower than its fundamental value. If the predominant sentiment on a particular stock is generally negative, investor perception of it can negatively affect its value and exaggerate the risks and downfalls of the company’s stock. Contrarian investors conduct research to determine which of the distressed stock to purchase, so that they can sell it later when the company recovers, which in turn works to increase stock value. This also results in higher returns from securities than usually expected and shows that being too enthusiastic over stocks that have been hyped can have the reverse effect.
Contrarian investors, therefore, tend to always look at the market, which leads to having a healthy level of skepticism that helps them to pick up investors’ real feeling about the market. Exaggerated valuations often result in drops when the expectations of investors are not met. So, contrarian investment is a flexible approach that you can use in individual stocks, markets, and industries.
Similarities to Value Investment
Contrarian investing is quite similar to value investing in that, both approaches can be used to perceive inconsistencies in investment prices, as well as spot if the current market contains any undervalued asset class. Both approaches look for stock that has been undervalued so as to turn a profit based on analyzing investor sentiment in the current market. The primary difference between these two tactics is that value investing places particular importance to P/E ratio whereas contrarian investing sees it as a secondary consideration to the qualitative state of the market, which incorporates analyst forecasts, media commentary and trading volume.
Relationship with Behavioral Finance
Contrarian investors also utilize certain fundamental principles of behavioral finance, which considers the interaction between trends and investors collectively. For instance, a stock that’s not performing well is probably going to continue performing badly for some time to come, whereas a strong stock will probably remain secure for a long time to come as well.