Navigating the Retirement Risk Zone

Today we're going to
be talking about sequence of returns risk

and how to plan for it in your retirement
planning efforts.

Sequence of returns risk
is the risk of negative market returns

near or during the time when you will take
withdrawals from your retirement assets.

And it's particularly pernicious
for people that are within 5

to 10 years of retirement or in the first
five years of their retirement,

because it has an exponential effect
on portfolio depletion.

Welcome back to Navigating
the Retirement Risk Zone.

I'm Eric Amzalag,

a certified financial planner and
retirement income certified professional.

I'm also the owner of Fee
only financial planning firm

Peak Financial Planning.

For the next
15 to 20 minutes,

we’re going to do a deep
dive down the rabbit

hole of sequence of returns risk.

Not from an academic perspective,

from a very practical
how do you plan for it perspective.

I'm going to explain what it is,
how to understand it,

and how to plan for it
in your retirement planning efforts.

And be sure to stick around for the back third

of this podcast, because that's where
I'm going to address the investment

specific strategic elements of how to plan
for sequence of returns risk.

So there are two layered principles
that make up sequence of returns risk.

The first layer is
what's called the unequal relationship

between market declines
and positive market returns.

Now, I'm going to give you a real time
example of this.

I'm going to ask you
a really quick question,

which is when your portfolio
has a 10% loss in the portfolio,

how much gain do you think is required in
order to recover just back to break even.

So I'll give you a couple seconds
to think about this.

If you lose 10%, how much gain
do you need to get back to break even?

And the answer is
when you lose 10% of your portfolio value,

you actually need 11.11% of a market
return to get back to break even.

There is
what's called an unequal relationship

between market declines
and market returns.

And that's because when you lose value
in your portfolio, your new starting

principal amount or your new baseline
portfolio value is the lower value.

An easy quick math example,
if you have $1 million portfolio

and you lose 10% of the value,
that leaves you

with $900,000,
you lost $100,000, which is 10%.

You're left with $900,000.

In order to get back to $1 million,
you need a rate of return

that is based off
of your new $900,000 portfolio.

So you need an 11.11% return,
because you need

$100,000 of growth
to get back to $1 million.

And this relationship becomes bigger
and bigger the greater the loss.

A 20% market decline
or let's say portfolio

decline means a 25% rate of return
or a 25% return, not rate of return,

25% return to get
back to break-even.

A 50% market decline requires an 100%

return to get back to break even.

Now, I'm not saying that
because 50% declines are likely,

but only to illustrate

this kind of exponential spread
that happens as the losses get larger.

Okay.

Now, the most important part of this
example is not just how big of a return

you need in order to break even,

but how long it takes
to get back to break even.

And the answer is, if you use the historic
average return of the S&P 500,

which is 7.44% after inflation, then you
if you have a 10% decline and you need

11% roughly to get back to break even,
that takes one and a half years.

If you have a 30% decline,
and that requires a 43% recovery

to get back to break even, that can take
five and three quarters years.

Now, obviously, circumstances
will be different person to person

based on how their portfolio is invested,
but also based on the market returns

after the decline.

But the idea here is if we're using
historic data to give us an indication,

this just illustrates what I call
the unequal relationship between declines

and returns, and illustrates
how much longer it takes

than we expect to get back to
break-even if we lose portfolio value.

Now that's the first layer
of sequence of returns risk.

The second layer is
what happens when we add in distributions

on top of market declines.

So what if you're retired and you're
drawing income from the actual portfolio.

Well, let's say
when you have a 10% market decline

or a portfolio decline
and you take a 4% distribution from it.

Now you've withdrawn 14%
effectively from the portfolio.

There's that 10% loss
and the 4% distribution.

And you need a 14.9% recovery
to get back to break even.

Again, the relationship gets exponentially
worse the bigger the decline.

If you have a 20% decline, let's say,
in one year, and you also take 4% out

now instead of needing a 25% recovery
to get back to break even,

you need a 28.6% recovery
to get back to break even.

And that is actually what sequence
of returns risk, it’s when you combine

unequal relationship between market
declines and market recoveries,

or portfolio declines
and portfolio recoveries,

with also taking distributions
from the portfolio.

Now, why is this particularly pernicious?

And it's particularly pernicious
and dangerous

when using retirement planning tools.

And that's because most retirement
planning tools

will default to using straight line
rates of investment returns

in their illustrations
or in their analysis.

What that means is most retirement
planning tools, if you plug in your asset

allocation, it'll generate
an average rate of return.

Let's say you do a 60/40 portfolio
and it spits out that that 60/40 portfolio

has historically had a 6% rate
of return year over year.

It's going to apply that

6% rate of return to every year
for the rest of your plan by default.

The problem is, markets
don't actually work that way.

You have different rates
of return every year.

You may have an average of 6% over a 30
year period, but there is no scenario ever

in reality where you will have a flat 6%
rate of return every year in retirement.

Most of us intuitively know this,
but we don't.

And if we don't look under the hood
of the retirement planning

tool or use some of the suggestions
I'm going to give later in this podcast,

then we're going to get blindsided

when we look at the probability of success
in our retirement planning tool

and don't understand
that this is using a flawed investment

rate of return application.

Which leads us to the most important part
of this podcast, which is

how do we plan for
or protect against sequence of returns?

I believe there's a three part strategy
to this.

The first part is what I call
comprehension.

First, we have to understand layers
that lead up to sequence of returns risks

so that we can make good decisions
with our strategy.

And that means, number one, understanding
the two components mentioned before,

which are the unequal relationship
between market growth and market declines.

Or, you know,
you could substitute

the word portfolio, portfolio growth
and portfolio declines.

And not just understanding the unequal
relationship, but also understanding

the exponential amount of time
it takes to recover those losses.

The second part of comprehension
is understanding how portfolio

withdrawals additionally impact
the recovery timeline.

Okay. So we just covered that.

Now the second part of planning
for sequence of returns risk

is proper retirement planning.
And we address this a little bit.

But the first element of this is number
one don't rely on Monte Carlo

or retirement planning tools’

Probability of success.

It will mislead you.

You need to look deeper

than just using a probability of success
on a retirement planning tool.

And the way you do that is you stress test
your financial plan

with multiple investment
rate of return scenarios.

You can actually, in many tools, build in your
own rate of return sequence of returns.

You can also download

historic rates of return online
and apply those to a financial plan.

Now you also want to use multiple withdrawal
and spending strategy scenarios as well.

So it's not enough to just think
about the rates of return on investments.

You have to combine that with the actual

spending strategies or spending behaviors
that will likely get used in retirement.

So that is layer
two of how we protect against sequence

of returns risk, which leads to finally
layer three, which I think is

what most people are most interested in,
which is the investment strategy.

Now, I recommend, this isn't
financial advice, but I recommend thinking

of your investment strategy this way,
which is a bottom up

withdrawal strategy first,
and then your investment strategy.

All right.

Now most of the time we begin
with the investment strategy first,

which is building an asset allocation

and then filling the investments
in that satisfy that asset allocation

and then filling in a withdrawal strategy
that supports that asset allocation.

It's important to all still
always have the asset allocation in mind.

But I recommend that

when planning for sequence of returns
risk, we flip that kind of upside down.

And we start with simple
withdrawals first.

And this is actually practically
applicable to managing sequence

of returns risk.

The first withdrawal rule
would be something like the following.

Take withdrawals from portfolio growth
when portfolio values are up.

to preserve cash and cash like
investments that are held within the portfolio,

and then take withdrawals from cash
and cash like investments

when portfolio values

are down to allow time for investments
that have lost value to recover.

I’m going to repeat that.

Simple withdrawal rule that
helps with sequence of returns risk.

Withdraw from portfolio growth
when portfolio returns are good,

in order to preserve cash and cash
like investments,

and then withdraw from cash and cash
like investments when portfolio values

are down to allow time for investments
that have lost value to recover.

That makes sense.

That probably sounds a lot
like a bucket strategy, and it kind of is.

Although I'm not necessarily telling you

that you have to use a bucket strategy,
but you do want to think of your

investments in buckets.

And the reason we started with
this withdrawal strategy

is because now, depending on your ability
and level of wealth,

we want to build an asset allocation
that will support the withdrawal strategy

I just mentioned.

Withdrawing from portfolio growth

when portfolio values are up,
withdrawing from cash and cash

like investments,
when portfolio values are down.

Okay?

Each person and every one of you
listening to this podcast

or watching this, wherever you watch it,

we'll need to determine the
amount of cash and cash

like investments
that they can support in their portfolio

and still meet their desired
spending needs and retirement.

That's a completely unique
and individual exercise.

Some people with more wealth
will have more ability

to have more cash and cash,
like investments in their portfolio,

and people with less wealth
will have less flexibility

with how much cash and cash
like investments

they have in their portfolio,
and to still be able to meet

their rate of return requirement
and therefore how much they want to spend.

Now, having said that,
let's move to the next step.

So we've talked
about the withdrawal strategy.

Now we talked about the asset
allocation concept

which is layers
on top of the withdrawal strategy.

Now we're going to talk about how you do

the investments that fill in
or support the asset allocation.

So the idea would be to choose
specific investments

that fill in the asset allocation
and actively support the hedging goal

you have in mind.

Hedging meaning the
insurance score, right?

We are using an investment strategy here,
or we're proposing an investment strategy here

that hedges against sequence of returns risk
by giving you a withdrawal strategy

that helps you preserve decline in value
investments by using cash and cash

like investments,
and allows you to preserve cash and cash

like investments by using portfolio growth
in the opposite scenario.

And we want investment specific
selection that fills in this,

the asset allocation that supports this.

So I'm going to give you a quick,
easy example where people have gone

historically wrong in thinking about
how to invest for protection

against sequence of returns risk.

The easiest example is intermediate
and long term bonds.

So if you use a traditional asset
allocation

and it tells you to go
60% stocks and 40% bonds, you might,

and many people suffered from this in 2022
when the market declined

and when interest rates went up
at the same time.

Many people had intermediate long

term bonds that are in the bond portion
of their asset allocation.

Their advisers or themselves are online

they were told or made to believe
that these were low volatility investments

because they're in the conservative
portion of their portfolio,

and that in some ways these might function
as cash or cash like investments.

And add on top of that,
because interest rates were so low.

many people may have been more heavily
indexed into the longer end of the bond

curve or a longer duration, longer
timeline bonds,

because they were getting
slightly more interest

than the lowest interest rate
and shortest term bonds.

And because of that, they suffered major
portfolio value declines

and did not have a sufficient cash
or cash like bucket

because too much of their bond money
was invested in the wrong types of bonds.

And this happened because the asset allocation
says that the bond part of the portfolio

is the defensive part, and they ended up
in this kind of train wreck

that could have been avoided
if they had understood this problem.

So the point here is choose
your investments specifically

so that they satisfy the cash and cash
like portion.

And how much do you think you need
in that type of bucket, and

how much should go into the growth portion
that you will use to prune in positive

market return years?

The last part of the investment strategy
here is probably the most controversial,

which is to diversify
out of concentrated positions.

It is my opinion, and I think the data
shows this, that having more

individual investments
reduces concentration risk.

That's the concept of diversification,
right?

We're told that we should
invest in the broad

stock market or a basket of stocks
or maybe index funds that spread our money

around many investments
because that reduces concentration

risk and increases diversification.

Concentration risk,

by the way, specifically means
having too much money in one investment.

And then if the market

or that investment specifically goes down
because it's too large

a proportion of your investment monies,
it drags your whole portfolio down.

Having more positions
reduces that concentration.

And it allows for

what I call investment
specific pruning when markets decline.

What I mean by that is not all stocks
or not all funds for that matter

go down just because the market
as a whole goes down.

Actually, in many cases,
we've had markets that have declined

and there have been specific funds
or specific stocks or specific sectors

that did not decline
with the broader market.

When you have more diversification

in that manner,
you can prune those specific investments.

because they may have grown
or have flat stayed flat, and that can act

as another buffer, to protect
against this sequence of returns.

As a real life example,
a three fund portfolio

only has so many areas where you can prune
while waiting out a recovery.

And we might be told that a three fund
index fund portfolio

because it's invested in index funds,
which are the index funds themselves

are invested in a broad basket of stocks,
or the market as a whole are diversified.

The fact of the matter is,
they're not actually diversified

when it comes to withdrawing money,
because you can't actually only sell

like if the if VTi, an index,
a S&P 500 index fund goes down in value,

you can't go to your account and say,
I only want to sell the, energy

sector of this fund
because the energy sector was actually up

while the rest of it was down.

You can't do that.
You have to sell the fund itself.

You can't prune in specific manners.

And so that's a good example of where

having more diversification,
maybe fewer more funds or more stocks,

or maybe using some blend of funds
and individual stocks,

along with your cash and cash
like investments,

can actually be a hedging mechanism
for sequence of returns risk.

Now, let's put this all together
because thinking about planning

for sequence of returns
can feel kind of yucky.

The problem

with hedging against sequence of returns
risk is that when markets are going

well and your portfolio,
values are going up,

we just think we don't need
to hedge against sequence of returns risk.

However, hedging is like
purchasing insurance.

In many of our lives.,

in many areas of our lives,
we buy insurance.

You know, we hope that we'll never need
to rely on that insurance

and we'll be thrilled,
you know, if we die and having paid

the insurance premiums our whole life
but never had to call upon the insurance,

and we still purchase that insurance
because it's prudent, right.

So portfolio strategies
to protect against sequence of returns

risk serve the same function.

When markets are going up,

like I said, it's
going to feel very unpleasant to watch

the hedging portion of your portfolio
underperform the rest of the portfolio.

But I'll leave you
with this final reminder,

which is it's not an investment strategy

if you don't have a hedge
that is called gambling.

And so you can think of the strategy
we outlined in this podcast as

portfolio insurance
for the eventual possible

contingency, where sequence of returns
might negatively affect you in retirement.

As a financial advisor myself,
and as just a nice person,

I hope it never affects anybody
I ever work with.

It doesn't affect any of you watching
or viewing or listening this podcast,

but just like insurance, we purchase it
for the contingency where I might happen.

And so that is basically the podcast here
on Sequence of Returns Risk.

I hope you enjoyed the topic.

Please give this, subscribe
to this podcast, wherever you may listen.

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if you could write us a review.

Let us know your thoughts or your comments
on this episode or the other episodes.

And if you'd like to learn more
about how we help our clients

at Peak Financial Planning, you can visit
our website at www.thepeakfp.com

Thanks for your time and
attention and see you soon.