The Portfolio That Helped You Achieve Retirement May Not Be The One to Get You Through Retirement!

We are often so focused on saving enough to achieve financial independence that we may fail to address the concern of how our portfolio will perform once we retire. Simply put, it's not only about how your assets are allocated and the average return of those investments over time, but also—importantly-- the order in which those returns occur; known as the “Sequence of Returns.”

Sequence of returns risk refers to the danger of experiencing negative returns early in retirement; this can have a disproportionately negative effect on the longevity of your savings. For example, because withdrawals in retirement are typically made from a fixed pool of assets, poor returns early in the process can deplete this pool faster than anticipated.

To illustrate this phenomenon, consider the example below of two retirees:

The Case of Two Retirees: John & Mary…

Both retirees plan to retire in 2025 with $1M in savings. Each will need to withdraw $40K a year (indexed by an inflation rate of 2%) to help supplement retirement expenses, and both will experience two consecutive years of (-15%) returns. The ONLY difference is that John will experience these negative returns during the 1st and 2nd years of retirement, while Mary will experience these negative returns much later in her retirement; in this scenario, during years 10 & 11. The outcome for each retiree is VERY different even though the average return is the same!

Let’s take a look at how this might play out via the graph below…

Despite having the same average return over time, John, who experienced the early negative returns, may find his portfolio depleted much sooner than expected, and clearly sooner than Mary’s.

How can you prevent this from happening?

Certainly, we cannot control how the market is going to perform in the years immediately following when we stop working.  And any large draw-down on your investment portfolio could impact your withdrawal rate.  As an approximate rule of thumb, a retiree might consider withdrawing about 4% a year from an investment portfolio, feeling comfortable that he/she would not outlive the money. However, as illustrated above, adhering to a fixed withdrawal schedule can lead to drastically different outcomes depending on market performance in the early years of retirement.  

Mitigation Strategies

Given the potential impact of poor sequence of returns, it's crucial for retirees to consider strategies to mitigate this risk:

1. Build a Retirement Withdrawal Strategy Plan: Many retirees will have a few “buckets” from which their retirement expenses will be funded. These can include Roth/Traditional IRA’s, Social Security, pensions, taxable brokerage accounts, as well as any part-time or other forms of income. In order to maximize the potential for a successful retirement, retirees should consider the optimal timing to spend down each of these savings vehicles in retirement. For instance, if you plan to wait until 70 to start taking Social Security, you may want to consider pulling more assets from your pre-tax retirement accounts in order to reduce your overall income tax liability. In addition, your withdrawal strategy should be flexible during periods of market downturns, perhaps funding withdrawals from investments that have appreciated, thus allowing the other lesser performing investments time to recover.
2. Diversification: A well-diversified portfolio should spread risk across multiple asset classes that are not highly correlated; this can potentially reduce the impact of poor performance in any one area of the portfolio as other investments can offset those losses. Important note: Just owning the S&P 500 is NOT a diversified portfolio! Above average returns in the S&P 500 over the past couple years may lead investors to believe that only owning this one index is all they need; however, over many other market periods, irrespective of the last 10 years, having a truly diversified portfolio--a portion of which includes the S&P 500-- has proved to be much more advantageous.  Do not let recency bias influence your important retirement decisions!
3. Hedging: Placing investments in your portfolio that can reduce the risk/volatility in a portfolio, while also providing some modest upside during a market upturn. 
4. Income Generation: Consider adding investments that generate income for your portfolio. As we always emphasize, dividend-paying stocks of blue-chip companies are a great source of steady income; option premium income & fixed-income investments are also good alternatives.
5. Asset Allocation: Adjusting your portfolio asset allocation as you approach and enter retirement; shifting to a more conservative allocation may not only help manage risk, but also volatility. 
6. Long-Term Perspective: Always maintain a long-term perspective; avoiding reactionary decisions based on short-term market fluctuations can help preserve the longevity of your portfolio.

Successfully funding your retirement requires careful consideration of various factors with the sequence of portfolio returns being a critical component. By understanding the challenges associated with taking large withdrawals during market downturns--especially in early years of retirement, as well as implementing appropriate strategies to mitigate these risks, you will increase the likelihood of not outspending your money in retirement.

Disclosures: This is not an offer or solicitation for the purchase or sale of any security or asset. While the information presented herein is believed to be reliable, no representation or warranty is made concerning its accuracy. The views expressed are those of NCM Capital Management, LLC and are subject to change at any time based on market and other conditions and NCM does not undertake to update or supplement its newsletter or any of the information contained therein. Past performance may not be indicative of future results.  Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be profitable. There is no guarantee that the investment strategies discussed above will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision. Investment advisory services are offered through NCM Capital Management, LLC, an SEC-registered wealth advisory firm domiciled in New Jersey. This communication is not to be construed or interpreted as a solicitation or offer to sell investment advisory services.  For additional information about NCM Capital Management, LLC, you may request a copy of our disclosure statement as set forth on Form ADV. Readers are encouraged to consult with their own professional advisers, including investment advisers and tax/legal advisors. NCM Capital Management, LLC does not provide legal or tax advice. NCM Capital Management, LLC can assist in determining a suitable investing approach for individuals, which may or may not resemble the strategies outlined herein. The graph above assumes that both retirees earn a 6% annual rate of return outside of the (-15%) drawdowns which are outlined in the text.