One of the most common words used in the investment world is risk. Of course, seasoned financial professionals will often qualify the term with a descriptor so that we get things like: market risk, interest rate risk, company risk, reinvestment risk, etc. In fact, the number of ways that risk can be broken down into specifics is somewhat overwhelming, especially if you’re a novice in the investment world.
My focus with this article series is to highlight a few major disconnects between clients and advisors when it comes to talking about risk. To put it simply, I feel that when the subject of risk comes up—specifically market risk—clients and advisors are often discussing two different things. Financial professionals are often trained to understand or interpret portfolio risk in terms of statistics such as variance or standard deviation, while many clients think of portfolio risk simply as “How much can I lose with this investment?” In my opinion, this disconnect can result in some serious flaws when it comes to planning and executing a retirement income plan.
When a potential client is seeking financial advice, they may go about finding an advisor in a number of different ways. It’s possible that they will use Google to find local financial service firms, attend a retirement workshop or two, and ask trusted friends or family members who they would recommend. These are all common ways for consumers to seek information on service providers—no matter the industry. The financial services profession is no different.
Next, if that client finds a team they would like to meet with, it’s very likely that they’ll be asked to fill out a risk profile or a risk tolerance questionnaire in the first or second meeting. Assessing an investor’s risk tolerance is a must in our industry, and I have found that most advisors do this early in the client meeting process. The purpose of these questionnaires is usually to:
1) determine a client’s overall risk tolerance—how well they can deal with fluctuations in the market without pulling the plug on their investment strategy
2) discover if they are investing in a way that aligns with their stated risk tolerance
3) assist the advisor in making a recommendation that doesn’t violate the client’s stated risk
Once the risk tolerance questions have been asked and answered, it can be common for the discussion about risk to fade into the background, with both parties—client and advisor—thinking the topic is settled. Clients will often feel like they have been heard. Advisors will feel confident that their portfolio recommendations are suitable for the client. However, for clients that are attempting to plan for income in retirement, it’s imperative that this topic lead to a deeper conversation.
Modern Portfolio Theory, which uses mean-variance optimization, attempts to construct portfolios that aim to maximize return for a given level of risk. In this case—the lower the risk tolerance of the client, the selected portfolio would both reduce volatility (variance) and average expected return (the mean). This is often accomplished by reducing a portfolio’s allocation to equities and increasing the allocation to bonds. While most advisors are aware that bonds are not “safe” assets— clients often view bonds as being “safe” or conservative. Risk tolerance questionnaires are a tool that advisors use to aid them in selecting this optimal portfolio.
So, how does the retirement planning client need to look at risk differently? In the next few articles, I’m going to explore a few different areas where I feel that clients focusing on their retirement years need additional guidance.
Sequence of Returns Risk
One of the most damaging events to an investor that is nearly or newly retired can be the onset of a bear market. During one’s accumulation years, bear markets are never fun—they can even be downright unnerving (think about the financial crisis of 2008). Yet, if investors can remain disciplined and patient, they should be able to participate in the eventual market recovery and expansion to new highs.
Clients who are hoping to retire, however, may not have the luxury to be patient. Income from their investments could be an essential ingredient to their retirement lifestyle, and an ill-timed bear market can be a serious threat to the sustainability of their retirement funds. Clients who retire and immediately face a bear market can find themselves potentially struggling with a number of undesirable decisions: reduce or eliminate planned portfolio withdrawals, find part-time income, work longer, or claim social security income earlier than planned (I dislike this one the most).
Let’s just look at a simple example to illustrate this concept…
We have a couple, Joe and Janice, who are hoping to retire in 2 short years. They have been fortunate with their saving and investing, accumulating $1,000,000 in retirement assets. Joe and Janice consider themselves to be moderate investors, meaning they will accept some market risk in their portfolio; and for retirement income, they hope to have their portfolio provide them with $40,000/year in addition to their social security benefits.
By traditional retirement planning standards, this comes to a 4% initial withdrawal rate—synonymous with the 4% rule that has endured in the financial sector for decades.
Joe and Janice feel confident as they move into the final phase of their working years, and in an effort to make sure they are headed down the correct path, they engage the services of a well-known investment firm in town. Joe has always felt that he was competent with investing decisions, but Jane reminded him that their retirement was too important to not work with a professional. Once the initial meetings were finished, they agreed that Joe and Janice would be ready to retire as planned, utilizing a traditional 60/40 portfolio allocation. This allocation is often considered a moderate allocation within the investment industry; therefore, it would most likely be suitable for Joe and Janice. They agreed that they would meet once a year with their new advisor to discuss any changes required by the plan and to implement a 3% increase in their income to adjust for inflation.
But then a bear market hits….
Over the next 24 months, the markets slide swiftly. Joe and Janice watch as their portfolio values go from $1,000,000 to $720,000—a 28% decline. The planned retirement date arrives, and Joe and Janice are faced with a dilemma:
Do they spend less?
Do they work another year and hope that the market recovers?
Joe and Janice meet with their advisor and they go over the new scenario for them: the initial withdrawal rate of 4% would now only allow them to withdraw $28,800 from their current account balance. If they decided to withdraw the same $40,000 in year 1, the initial withdrawal rate would be 5.6%–much higher than is recommended for a healthy couple in their early/mid 60s.
But, what about the portfolio? Won’t the market recover if they stick to their investments? It’s very likely that the market does recover for them. However, the math has now changed. To just get back to even, they don’t need to get back the 28% they lost. No, it’s worse—they need to get a gain of 38.9% to just get back to even!
What if they retired and took their entire 1styear of income ($40,000) from the portfolio in hopes that the market would begin a recovery? Now they need 47% in gains to get back to their original $1 million.
As you can see—getting hit with a poor sequence of returns can have a significant impact on the trajectory of one’s retirement years. I could continue down this path with dozens of additional variables in this example, but the point I’m trying to make is this: being risk tolerant as an investor doesn’t insulate you from the potential catastrophic consequences of a poor sequence of portfolio returns in retirement. Joe and Janice were risk tolerant, and they were advised to invest in a moderate portfolio allocation that aligned with their risk tolerance.
Unfortunately, sometimes the market doesn’t cooperate with our plans. It doesn’t always have to be because of poor planning or investor naivete; sometimes it can simply come down to just having bad luck. The good news is that there are a number of strategies that may help clients prepare for sequence of returns risk. If you are nearing retirement, or if you are recently retired, and this risk concerns you; please don’t hesitate to reach out to our team. We have a number of tools that we can use to evaluate your portfolio and your exposure to sequence of returns risk. Don’t let the next bear market catch you off guard. Reach out to our team today!
Note: The example used in this article is hypothetical and oversimplified on purpose. It should only be considered as an attempt to educate readers on the concept of sequence of return risk.
Investment advisory and financial planning services offered through Planners Alliance, LLC, a SEC Registered Investment Advisor. Subadvisory services are provided by Advisory Alpha, LLC, a SEC Registered Investment Advisor. Insurance, Consulting and Education services offered through Vertex Capital Advisors. Vertex Capital Advisors is a separate and unaffiliated entity from Planners Alliance, LLC and Advisory Alpha, LLC.