Recently, I sat down with two long-term clients (both savvy investors who have steadily nurtured and grown their retirement nest egg for well over two decades) to review their financial plan. In doing so, we first needed to make an assumption around what return they could reasonably expect to make on their money during retirement. All three of us felt comfortable factoring in a return of about 4%, conservatively shy of their actual 5-7% annualized returns over the long term.
It came as a surprise to us all, then, when we looked back and found that despite ending the overwhelming majority of their years in the green, their actual calendar-year returns ranged anywhere from high teens in some years to occasional single-digit negatives in others, and even one glaring 20% drawdown (in 2008). In fact, over more than two decades of investing, there were only four times where they’d landed perfectly within their target range.
The first thing this anecdote shows is that time smooths the highs and lows of investing. So creating a mandate with an advisor – and sticking to it through good times and bad – is the best way to achieve your desired nest egg in the end. The second, and less evident, is that as investors enter retirement and begin to draw down on their portfolios, their sequence of returns – or the order in which they will experience them – starts to matter almost as much as the total returns themselves.
Let’s pivot for a moment to two sets of hypothetical investors, the Smiths and the Joneses, who are each on a different retirement “adventure”. Both couples retired with $1M in liquid assets 25 years ago, and through a fantastic twist of fate, they’ve managed to earn the exact same calendar-year returns over the years – but in the opposite order.
Despite their inverted sequence of returns (and only hitting their target return range thrice), the Smiths and the Joneses would have both ended year 25 with an annualized return of just over 5% and the same amount of dollars in the bank (see figure 1).
Figure 1: 25-year Earnings Without Withdrawals
Click here to see the annual returns by year.
Source: CWB Wealth Partners, returns simulated based on a balanced-growth mandate (70% equity/30% fixed income) mandate.
Except, upon retiring, both couples started to withdraw $50K from their portfolio at the start of each year. With withdrawals thrown into the mix, their sequence of returns started to make a real difference (see figure 2).
Figure 2: 25-year Earnings with Withdrawals of $50K/yr
Source: CWB Wealth Partners
Said another way, the fact that the Joneses had a “good” start to their retirement while the Smiths a “bad” one has drastically impacted their drawdown paths. To be clear, both couples have still comfortably funded the same quarter-century of spending. But the Joneses’ luck at the start of their retirement will allow them to leave a larger estate to their heirs if that is their goal.
The sequence of future returns is unknowable by definition, so this risk is difficult to account for even in the most advanced financial plans. That said, there are strategies that an advisor can incorporate into your plan if you do happen to retire in a less fruitful year, like 2022, or throughout retirement more generally. This will help ensure that your returns reach middle ground, giving you a smoother retirement journey.
- Dynamic spending rules
Dynamic spending can minimize the impact of an “unlucky” start to retirement and of the occasional (unavoidable) negative year throughout it. For example, instead of withdrawing strictly $50K every year, an investor could decide to only withdraw whatever dividends and income their portfolio generates. Of course, some years this might mean more than $50K and some years less, but this uncertainty can be alleviated by stowing away excess returns generated in “good” years to supplement less fruitful ones.
- Regular rebalancing
Often – especially after a fruitful stretch of market returns – investors are tempted to let higher-growth assets (like equities) balloon to a larger share of the portfolio. While it’s rarely a good idea to drift from your stated risk/return mandate to begin with, being disciplined about rebalancing is even more important once drawdowns begin. Otherwise, a retiree could find that they’ve drifted into a higher-risk posture just before a market correction that coincides with a drawdown need.
Some investors may even want to revisit their mandate as much as three to five years ahead of retirement, particularly if their retirement nest egg is already comfortably funded, and temper their equity exposure downward in advance.
- Time bucketing
Other investors find it useful to build layers of contingency into their portfolio at retirement. For example, upon entering retirement the portfolio could be re-allocated such that a year of immediate expenses is always safely stowed in cash or GICs; another two to five years in lower-volatility government and corporate bonds; and only the balance in longer-term equity investments.
This ensures that even if market returns are negative for 12 months or more, cash, GICs, and fixed-income investments can help support ongoing lifestyle needs without cutting into equity assets that are still temporarily depressed.
Sequence risk can have a tangible impact on your retirement. While a financial plan can’t predict future market conditions, it can let you test various assumptions and determine the best course of action. So, review your plan regularly with your advisor (especially three to five years before you retire) and course correct where needed to stay on those happy trails.
Sources: CWB Wealth Partners
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