Sequence-of-return risk is real, and devastating. —
Sequence-of–return refers to the impact of market gains and losses on a portfolio just prior to, or early in, retirement. The risk comes in the form of low or negative returns, which combine with withdrawals taken by the investor for everyday living expenses to accelerate a portfolio’s rate of depletion. If hit hard enough at the outset, a retiree may have a difficult time trying to recover, increasing the likelihood they may run out of money long before they run out of life.
Consider in 2008, the average investor lost almost 25 percent of their savings, according to the Investment Company Institute. However, for investors in the age 50 to 59 bracket, a demographic quickly closing in on retirement, the loss had a greater impact—over 30 percent. If returns diminished by a third at a time when funds were needed for gas, groceries and health care, the results could be catastrophic.
Here’s how sequence-of-return risk works. If two investors had the same account balance, yet investor No. 1 retired at the beginning of a sustained market rise and investor No. 2 at the beginning of a decline, the difference in the portfolio value for each over the course of their retirement is material, and significant. Investor No. 1 has a good chance of an affordable quality of life in retirement with assets to spare. Conversely, investor No. 2 has an equal or greater chance of running out of money or coming up short on their retirement goals.
It isn’t a pleasant scenario, but concrete steps can be taken to help ensure the risk is minimized, and that investors don’t outlive their assets; it’s called a personal portfolio stress test.
Once the exclusive domain of doctors’ offices and big banks, more financial advisors are copying the actions of their larger counterparts and stress testing the portfolios of their individual clients.
However, a note of caution; financial advisors and investment advisory firms will often provide clients with hypothetical illustrations of a particular fund or portfolio’s average performance over time, but averages are misleading, especially when sequence-of-return risk is involved. It’s critical to use realistic time periods that involve a correction and/or catastrophic market drop, as experienced during the “Great Recession” of 2008 and 2009.
In other words, it has to be honest, not something that simply advertises solid returns, and the resulting plan has to have some sort of automated strategy or provision, says Michael Niemczyk, president, Insurance professional and Investment advisor of MLN Retirement Planning, Inc., a registered investment advisory firm with offices in Grayslake and McHenry Illinois.
“A portfolio stress test has to involve the absolute worst of the market, and examine whether the client’s emotions and financial lifestyle can handle the worst case scenario.” he says. “When selecting various investment strategies and portfolios, they need to be automated, include some type of stop-loss, insurance against loss or something with a preset sell and buy algorithm that helps protect the investor from downside risk before it happens, not after.
Other best practices include engaging with a financial advisor who works closely with a team, such as an attorney, accountant and other specialists (sometimes even in the same office) to ensure all assets and all possible scenarios are accounted for during the test. However, the client should ensure the financial advisor is the “quarterback” of that team, as they have the most investment knowledge.
The results of the stress test might call for an automatic (and automated) move to fixed income investments like bonds when the market experiences a certain drop. Or assets can be automatically moved to contractually insured vehicles when a certain level is reached in order to help protect against downside loss, as well as to lock in gains.
Investors need to remember that investing involves risk, including the potential loss of principal and that not all investment strategies can guarantee a profit or protect against loss in periods of declining values.
Keep in mind there are various degrees of protection against losses within investment advisory products.
If a financial advisor starts talking about contractual guarantees and guaranteed income streams he or she is referring to fixed insurance products that are subject to the claims paying ability of the issuing insurance carrier.
Whatever the eventual solution, it all starts with a financial advisor, as well as a comprehensive test now in order to ensure minimal stress later.
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Release ID: 107299