After increasing almost 2,000 points from a closing low of 15,373 on Feb. 3 to a closing high of 17,280 on Sept. 19, the Dow Jones Industrials Average gave up almost 1,200 points, or 6.7%, in less than 30 days when it closed at 16,117 on Oct. 16.
With just seven trading days under our belt since the recent low, six have recorded gains, resulting in a net increase of 701 points, more than 4.3%. Consequently, 60% of the loss has been erased with the Dow Industrials closing at 16,818 on Monday.
Although it’s too soon to tell, this roller-coaster ride raises the question: Was the recent flash correction simply a temporary setback or was it a warning of something greater to come? For those of you who live in California, was it a tremor or was it instead a precursor to the “big one?”
Sequence of returns
For recent retirees and those contemplating retiring within the next few years, the flash correction brings to mind the critical yet often ignored investment risk known as sequence of returns. Aside from the possibility of an uninsured lengthy extended care event such as Alzheimer’s, this is the single most significant threat to most retirees’ financial security.
Too often when we’re planning for retirement, we assume average rates of return. We do this for the years leading up to as well as throughout retirement. Even when we use conservative rates of return, this often leads to a false sense of security about the possibility of running out of money.
The timing, or sequence, of returns directly affects the longevity of retirement assets. Although not as critical when we’re working and in an accumulation mode, it’s often the decisive factor for determining how long our retirement assets will last when taking withdrawals from our portfolio.
A few years of sizable negative returns at the beginning of retirement can be highly damaging to, or potentially deplete, one’s portfolio early in retirement. The best way to illustrate this is with three hypothetical scenarios. Each one assumes retirement at age 65, a beginning portfolio value of $1 million, annual withdrawals equal to 5% of the age 65 portfolio value with annual increases of 3%, and an average rate of return of 5% between age 65 and 90.
The following is a summary of the three scenarios, including description and age at which assets are projected to be depleted, with links to the spreadsheet for each scenario:
|Scenario Number||Description||Age Assets Depleted|
|1||5% Annual Return||89|
|2||Good Early Years||After 90|
|3||Bad Early Years||79|
How and when to plan
The sequence of returns illustrated in “bad early years” Scenario No. 3 is a very real and serious threat to one’s ability to retire and remain retired for individuals with high concentrations of equity securities such as stocks in their portfolio. No one wants to be forced to apply for a job at age 79 after being retired for 14 years.
Planning for the sequence of returns is crucial to successful retirement planning. Choice of strategy and timing are instrumental in addressing this key investment risk.
Given the fact that the sequence of returns is a potential obstacle for small as well as large portfolios, a sustainable income strategy for a portion of one’s portfolio makes sense in most situations. One or more deferred fixed-income annuities offered by highly rated insurance carriers, including deferred-income annuities and fixed-index annuities with income riders, can be used for this purpose.
A laddering strategy can be employed after a portfolio experiences sizable gains. Portions of equity portfolios can be transferred into single- and flexible-premium fixed income annuities with different start dates and lifetime income amounts when this occurs. In addition to selling individual stocks at or near market highs and diversifying sustainable income sources, this will often result in increased lifetime income distribution possibilities. This can be done with non-retirement and retirement investment accounts.
Transfers of a portion of equity portfolios into fixed-income annuities should begin at least 15 years before planned retirement to maximize the deferral period before beginning income withdrawals as well as the number of potential opportunities for implementing this strategy.
Don’t wait for another market downturn
Time will tell whether the recent stock market flash correction was a temporary setback or a warning of a more sustained correction. At a minimum, it should be a wake up call for individuals approaching retirement as to the destructive nature of the sequence of returns investment risk and potential planning strategies for dealing with it.
Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. Bob is also the sole proprietor of Robert Klein, CPA. Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies to optimize the longevity of his clients’ after-tax retirement income and assets. He does this as an independent financial advisor using customized holistic planning solutions based on each client’s needs and personality.