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Sequence of Returns Risk

April 29, 2020
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Typically the biggest fear for retirees is running out of money.

Today I am focusing on a risk that has a lot to do with this fear. Have you heard of Sequence of Returns Risk? Could you explain it to a friend? No? Perfect! I am so glad you are taking time to watch this video. You need to know about this risk and how to address it. Let’s get started.

Script

Hello everyone. I’m Doug Pardieck and I am an independent financial advisor. If you’ve watched my other video I’m sure you’ve heard me say this before, but I am going to continue repeating it: Our mission is to strengthen our community and families by helping folks make excellent financial decisions. One way we do this is by creating very good educational videos on a range of topics all relating to investing and financial planning. We want you to be informed and making good financial decisions.

I’ve mentioned before there are some significant risks that must be addressed when creating your comprehensive financial plan. These risks are real and if not addressed can derail your financial plan.

Typically the biggest fear for retirees is running out of money.

Today I am focusing on a risk that has a lot to do with this fear. Have you heard of Sequence of Returns Risk? Could you explain it to a friend? No? Perfect! I am so glad you are taking time to watch this video. You need to know about this risk and how to address it. Let’s get started.

Let’s start with a hypothetical scenario. You have 3 retirees all retiring with $1,000,000 and all three start with a 4% withdraw rate. Year #1 of retirement all 3 retirees take out $40,000. Each year they adjust for inflation and take out 2% more. This is called the 4% rule. When I became a financial advisor I was taught that this was safe withdrawal rate. Well, I am older now and wiser too. I am here to tell you that the 4% withdraw rate may not be safe. Let’s take a look.

On this first chart, you will see three investors and their annual returns. The blue bar graph shows investor #1. This retiree had a great start and a bad end. Avg annual return of 5%. The gray bar graph shows retiree #2. He experienced steady annual returns of 5.0%. The green bar graph shows retiree #3. Bad start. Great end. This investor also experienced an average annual return of 5.0%. Remember, they are taking withdrawals annual and increasing their withdrawal by 2% to offset the impact of inflation. How did they fare?

Let’s take a look at each investor’s experience over 30 years. Investor #1 was very successful. The 4% withdrawal rate worked with plenty of money left after 30 years. Investor #2 was successful as well, however after 30 years they now have less money than what they started with. Investor #3 ran out of money. The hypothetical illustration shows a 7 year funding gap. Remember, this is one of the biggest fears for retirees… running out of money!

How is this possible when the average return was the same for all 3 retirees? This illustrates the Sequence of Returns Risk. So, when you retire, how do you know if you’re going to be the unlucky investor or not? When you rely on the 4% rule, you don’t know. You won’t know until you’re deep into retirement and look back on the returns your portfolio experienced… and by that time it may be too late.

We have a strategy that help retirees address this particular risk. We use the bucket system which segments your assets into time periods. Our goal is to make sure you have assets to cover you throughout your entire retirement. Each bucket has a unique combination of investments focused on a different goal, a different time horizon. For example, assets placed into bucket 1 are selected with the goal of preservation without any exposure to the stock market. Bucket 2 is meant to cover your income needs in years 6-10 of your retirement. These investments are carefully selected with the goal of conservative growth, and much less volatility that your long-term portfolios. Together, the plan is designed to reduce this Sequence of Return Risk. If the market is plunging during the early years of your retirement, your plan is OK because you’re not forced to sell stocks while they are down. Your income is coming from a more stable portfolio.

 

So, what’s your plan? What are you currently doing to reduce this and other risks? Is your plan depending on the 4% rule and getting good returns in the early years? We believe there is a better way to manage your wealth.

To learn more about this planning strategy and how we manage wealth within each bucket or segment. Please come see us. We’d love to share this time-tested strategy with you.

Have a great day!

Diversification and asset allocation strategies do not assure profit or pretecta gains loss. Past performance is no guarantee of future results. Investing involves risk. Depending on the types of investments, there may be varying degrees of risk. Investors should be prepared to bare loss, including total loss of principal.

Securities offered through Registered Representatives of Cambridge Investment Research, Inc., a broker-dealer, member FINRA/SIPC. Advisory services through Cambridge Investment Research Advisors, Inc., a Registered Investment Advisor. Cambridge and Talon Wealth Strategies are not affiliated.