Two severe bear markets during the past decade have made many investors wary about how much of their portfolio should be devoted to stocks. This is particularly true of retirees who need to depend on their savings for income.
Caution is understandable, but most investors are likely unable to generate sufficient income for retirement without including stocks in their portfolios. The long-term growth potential of stocks remains an important ingredient to long-term financial security, even in retirement. How can investors balance the need for stocks while protecting against the risk of down markets?
An important but little talked about issue that retirees should consider is sequence risk, which relates to the timing of stock market returns and how it can affect a portfolio. The sequence of returns has little effect on a portfolio that is held for an extended period of time with the goal of accumulating wealth rather than generating income. For example, consider what happens with Bill and Betty, two individual investors who experience exactly the opposite returns in a portfolio during the course of two hypothetical five-year periods. Bill’s returns for five consecutive years were: 20 percent in year one, 6 percent in year two, 0 percent in year three, -6 percent in year four and -20 percent in year five. Betty’s investment experience was exactly the opposite: -20 percent in year one, -6 percent in year two, 0 percent in year three, 6 percent in year four and 20 percent in year five.
If both invested $100,000 at the outset of this period and let the money continue to grow without additional investments or any withdrawals, both would end up with $95,654. While this isn’t likely the return they’d hoped for, the sequence of returns alone had no impact on their end result.
The concern is magnified for those investors taking withdrawals from an equity portfolio. Weak market returns occurring at the wrong time could more quickly deplete their nest eggs. When withdrawals are made at the same time investments are losing value, the decline in portfolio value can be dramatic, which could jeopardize long-term financial security.
Let’s consider what happens to Bill and Betty, two investors who retire during two completely different market cycles and experience returns exactly the opposite of each other. (See box.) For Bill, returns were strong early on, but in later years, performance declined. For Betty, returns were poor in the early years, but improved over time. In this case, each withdrew $5,000 per year in income from their $100,000 portfolio.
As the numbers show, even though Bill was taking money out of the account each year, the value of his savings grew in the first two years. As returns deteriorated, the value of the account declined more significantly. Still, he ended the five years with considerably more money in the account than Betty. The negative returns Betty experienced in the first two years, combined with her taking money out of the account for income, greatly reduced the value of her account.
One way to overcome sequence risk is to split retirement savings into different “buckets”:
- Bucket No. 1 – Put enough money aside in cash-equivalent investments where principal is secure to pay one to two years of current expenses.
- Bucket No. 2 – Set aside enough money in investments subject to little or no volatility to meet income needs for the subsequent two to three years.
- Bucket No. 3 – Allocate remaining money in a diversified portfolio that can include stocks, as well as bonds and other types of assets. This money can be allowed to grow with no immediate withdrawals required.
Growing portfolio value is important to help a retiree maintain an income level through time that can keep pace with cost of living increases. There is no easy fix for unpredictable market volatility, but an individual with savings split in this way may be better protected from the potential impact of sequence risk.
Paula Dougherty, CFP, ChFC, CLU, is a financial adviser with Dougherty & Associates, Ameriprise Financial Services Inc. in Springfield. She is licensed in Missouri, Arkansas, Kansas, California and Arizona, and may be reached at paula.j.dougherty@ampf.com.
