Editor’s Note: Sequence risk refers to the order and timing of market returns. Salvatore M. Capizzi, executive vice president with Dunham Investment Counsel Inc, explains why sequence risk can be very troubling to near-retirees and retirees and shares steps advisors can take to try to mitigate it. Dunham & Associates is a San Diego-headquartered RIA and broker/dealer.
Rethinking65: Why is sequence risk often overlooked, and what makes it one of the biggest challenges for retirement savers?
Salvatore M. Capizzi
Salvatore M. Capizzi: Sequence risk is often overlooked because many retirees are conditioned to focus primarily on achieving a target rate of return for their retirement portfolio. Think of the 4% rule.
The retirees are taught to focus on 4% — a return, not the sequence of returns. In fact, recent discussions suggest that a withdrawal rate of 4% might work, but 5% might be overly ambitious, and 3.5% is better.
It is all return-oriented.
This narrow focus on returns fails to account for the potentially devastating and permanent impact that the order of positive and negative investment performance can have on a plan for retirement — even the most thoughtfully built plan.
Experiencing poor or negative returns early in retirement, when the portfolio value is at its peak, can be particularly dangerous. Withdrawals taken during this period can deplete a retirement portfolio and add a negative return, further shrinking the portfolio and leaving less principal to benefit from potential future positive returns.
This adverse sequence can rapidly erode a nest egg, potentially leading to the retiree going broke, regardless of the overall average rate of return achieved over the long term.
Rethinking65: We need to unpack the idea that sequence risk can have a permanent and irreversible impact on a retiree’s retirement portfolio due to experiencing poor returns early in retirement. This possibility of running out of money entirely, regardless of the overall average rate of return over the long run, is a frightening prospect. Can you provide an example to better illustrate what this devastating and lasting effect of sequence risk looks like?
As my story goes, Cinderella’s father left her and her two stepsisters $1 million each in his trust which, of course, was administered by Dunham Trust Company.
This money would become available to them only when they turned 65, and it would be the only money they had to live on in retirement.
However, at the trust reading, each daughter had to choose between two sequences of returns.
They could choose a negative 8% rate of return for the first 10 years of their retirement, but then a positive 40% rate for the next 20 years. This equated to a 22% average annual return, and the investment of $1 million in these returns would grow to $363 million.
The other option they could choose was a 10% return for the first 15 years of their retirement and a 0% return for the next 15 years. This yielded a much more modest 4.7% annual rate of return, and the $1 million would grow to slightly over 4.1 million in 30 years.
As you would imagine, the stepsisters took the first option: -8% for the first 10 years, then a 40% rate of return for 20 years. On the surface, who wouldn’t want a 22% average annual rate of return?
To everyone’s surprise, Cinderella picked 10% for the first 15 years and a 0% return for the next 15 years for the 4.7% rate of return.
Cinderella realized she and her stepsisters would initially each need to withdraw $40,000 a year to live during retirement, a figure that would increase by 2% each year due to inflation.
Her stepsisters were focused on return, while Cinderella focused on the sequence of return.
The stepsisters ran out of money by their 19th year of retirement, and Cinderella had $2.5 million in her 19th year and still had $1.8 million at age 95, despite receiving a 0% return for the last 15 years.
Why?
It is all about the sequence of returns.
By the way, when the stepsisters went broke, they had to move in with Cinderella, and guess who was now doing the daily chores!
Rethinking65: What steps can financial advisors take to navigate sequence risk for clients?
Capizzi: There are several steps a financial advisor can take to navigate sequence risk.
First, while interest rates are high, build a laddered bond portfolio to protect the principal if held to maturity, and you should generate an adequate rate of return.
The issue will be whether or not interest rates start coming down. If they go low enough to where we were before 2022, then this strategy will not provide growth over a long lifespan for the client.
Many financial advisors use bucket strategies, which divide assets based on time horizons. The caution here is that I see strategies calling for 15 months of income in a money market account and the second bucket in a 3-to-7-year time horizon. If interest rates decrease again, you may not provide enough growth for clients who live a lot longer than expected.
You can also build a sensible asset allocation and provide diversification with an appropriate mix of assets of stocks, bonds, cash and alternatives that align with the client’s risk tolerance and time horizon. The caution here is sequence risk, and with the S&P 500 hitting over 30 new highs in 2024 alone, a dollar-cost-averaging strategy could make sense.
A dynamic withdrawal strategy is a better, but perhaps more painful, approach for a retiree. In this strategy, flexible withdrawal policies adjust the retiree’s income based on portfolio performance, providing lower withdrawals after down years to preserve principal.
Annuities can also be used, but if the client lives longer than expected, it may lack the needed growth.
You can also find overlay equity strategies. At Dunham, we have a strategy to combat sequence risk, but it still endeavors to provide growth that can fund clients’ lives during ever-expanding lifespans.
Rethinking65: With increasing lifespans and health spans, how significant is accounting for longevity?
Capizzi: We have what I call “The Retirement Paradox.” This paradox encapsulates the three interrelated risk factors associated with retirement.
Inflation poses a risk of eroding purchasing power over time in retirement.
Longevity risk means having enough assets to fund a potentially very long retirement— even into your 100s!
Sequence risk from equity market volatility can deplete assets rapidly, especially in early retirement years, leading to the retiree going broke.
Here is the paradox:
Equities are typically recommended to outpace inflation. And equities are typically recommended for growth and are needed if you plan on living a long life. However, equities’ volatility exposes retirees to the potentially disastrous sequence of poor returns early in retirement, which can devastate even the best laid retirement plan.
The Retirement Paradox is evidenced by the fact that the one thing that can help mitigate inflation risk and fund longer lifespans is the very same thing that can lead to sequence risk and an early drain of the retiree’s portfolio.
This is where dollar cost-averaging and equity strategies geared toward retirees, which may provide growth but also aim to combat sequence risk, come into play.
Rethinking65: And what are other key considerations which may be overlooked by clients?
You cannot ignore the psychological toll of sequence risk. Experiencing significant losses early in retirement can be emotionally challenging. It may tempt retirees to make impulsive decisions, such as selling investments at inopportune times or altering their spending plans in a way that compromises their long-term financial security.
As a financial advisor, you must stay attuned to these emotions and be there when times get tough.
Finally, in my view, it is unwise not to be overly frugal early in retirement, at the expense of missing out on bucket-list goals and fun retirement experiences.
Retirement should be enjoyed, so taking advantage of relatively good health and mobility early in retirement is important for enabling retirees to pursue passions, travel where they’ve always wanted to visit, and spend quality time with loved ones while they are still able-bodied.
Remember, there is no guarantee how many active years any retiree will have.
However, balance is key.
As financial advisors, you should not encourage your retired clients to splurge recklessly, but instead to allocate reasonable funds for bucket-list pursuits.
This can be immensely rewarding if it aligns with their financial plan.
Advisors can help quantify what is affordable because retirement years are precious. Prudent indulgence early on to enrich lives and check off ambitions should not be delayed until it is too late to engage in these activities fully.
Strategic splurging now can prevent regrets when health declines later.
