8 minute read
A Modern Take on a Classic Tale: The Tortoise, the Hare, and Sequence Risk
As a child, one of my favorite bedtime fables was the classic story of “The Tortoise, the Hare, and Sequence Risk,” which I am sure all our parents told us.
The fable starts in the forest, where a 67-year-old tortoise announces to all her forest friends that she will retire. But leaning against a tree, snacking on a carrot, is a hare who quips, “Ha! I am three years old and will retire next year, and I bet you my retirement income will last longer than yours.”
Tired of the hare’s constant bragging, the tortoise took the bet and started down the road of her retirement. With the S&P 500 at 4,700, the tortoise’s financial advisor, the owl, put her in a diversified portfolio of stocks and bonds.
A year later, when the Hare was ready to retire, the S&P 500 was at 5,875, which netted a nice return for the tortoise starting her golden years.
“Here I come!” The tortoise heard the hare yelling behind her.
But the moment the hare invested in stocks to start his retirement, the New York Giants did not make the NFL playoffs again, which caused the S&P 500 to decline sharply on the news. The S&P 500 dropped to 4,990 by the end of the year.
The hare, unfortunately, ran into the issue of Sequence Risk, the danger found when taking monthly income from his portfolio while stocks were losing value.
This damaged the hare’s overall return and challenged his ability to retire comfortably.
Put simply, the hare’s monthly income withdrawals from his account during a declining market were more costly than the same withdrawals the tortoise took during a rising market a year earlier.
The tale of “The Tortoise, the Hare, and Sequence Risk” teaches you and your clients a valuable lesson - the significance of sequence risk.
The hare, greedy at the prospects of the high market, faced the consequences of ill-timed withdrawals during a market downturn.
The moral of this classic Aesop fable is the wisdom of minimizing sequence risk in retirement and not being a New York Giants fan.
I learned only one of the two lessons.
Understanding Sequence Risk
Sequence risk is the order in which investment returns occur.
It is the risk that an investor will experience negative portfolio returns very late in their working lives or early in retirement.
This is important because retirees need more time to compensate for losses compounded by the simultaneous drawdown of monthly retirement income distributions.
The implications of this risk are critical to steering their retiree clients toward a financially secure and sustainable retirement.
Why Sequence Risk Matters For Retirees
Sequence risk extends beyond the concept of average returns. For your retiree clients, directing your focus to the timing of these returns is critical in retirement planning.
The key concept is that it is not just about the return numbers, but the sequence of these returns that can make or break a retiree's retirement plan.
In our view, strategies that take some of the edges off sequence risk and accelerate recovery time in the market should be included in your planning.
The Morningstar Study: Sequence Risk in Action(1)
Morningstar conducted a study examining two retirees with a $1 million portfolio. They looked at 30 years of retirement, each needing an identical $40,000 of assets for the first-year income, with the initial withdrawal amount increasing by the annual inflation rate of 2%.
They then said that hypothetically, for each ten-year period, their portfolio return would either:
(1) Break even.
(2) Gain 6%
(3) Gain 12%
They looked at the portfolio achieving each of these annual totals for ten years out of 30 but in a different sequence. Therefore, each of the two investors will earn an annual 5.89% gain over the entire 30-year period.
Their research shows why it is not about average return, but the sequence of those returns that matter.
The Results
The first retiree enjoys a strong start with ten years of 12% returns, followed by a decade of 6% gains, and then breaking even. In contrast, the second retiree experiences the reverse, ten years of breaking even, followed by a decade of 6% returns and ending with 12% results.
Each retiree is on track for an identical average annual return of 5.89%.
The first retiree's account value sits at $2.7 million at the end of 30 years, leaving a generous legacy for their family.
In stark contrast, the second retiree faces financial hardship, going bankrupt by the year 26.
Source: Morningstar
Why Such a Sharp Difference?
Morningstar explains sequence risk in terms of withdrawal rates. By year 11, the scheduled withdrawal amount for both retirees is $48,760.
First Retiree
However, the first retiree with the better start has $2.2 million in their account. This means that the $48,760 income for year 11 represents a 2.2% withdrawal rate and can absorb the withdrawal easily with a 6% portfolio return.
Second Retiree
In contrast, the second retiree, with an account value of $562,000, the same $48,760 income for year 11, represents an 8.7% withdrawal rate and reaches the point where the portfolio further dwindles each year, leading to bankruptcy.
Please remember that the Morningstar study does not represent the actual returns of any investment and is purely hypothetical. But it does drive home important points for your retirement planning.
Three Lessons From Morningstar
Morningstar highlights three essential takeaways for retirees facing sequence risk:
- Even Mild Markets Pose Risks: Sequence risk isn’t limited to bear markets; prolonged low returns can also have significant impacts.
- Volatility Matters: Reducing volatility by including bonds or other low-risk assets can stabilize returns.
- Flexible Withdrawals: Adjusting withdrawal rates during downturns can help preserve portfolio longevity.
Final Thoughts
Sequence risk is a critical consideration in retirement planning, particularly for retirees navigating bear markets. The order of returns can drastically affect a portfolio’s longevity, making it essential to implement strategies that mitigate this risk.
Meanwhile, the MorningStar study provides valuable insights into the importance of strategic planning and risk mitigation strategies to navigate the challenges posed by sequence risk.
To learn how DunhamDC can help you mitigate sequence risk and enhance recovery time, contact us today at (858) 964–0500.
DunhamDC - Buying Fear and Selling Greed.
Sources:
(1) Sequence Risk during Retirement, by John Rekenthaler, August 25, 2022, https://www.morningstar.com/retirement/sequence-risk-during-retirement
DunhamDC Disclosure:
This communication is general in nature and provided for educational and informational purposes only. It should not be considered or relied upon as legal, tax or investment advice or an investment recommendation. Any investment products or services named herein are for illustrative purposes only, and should not be considered an offer to buy or sell, or an investment recommendation for, any specific security, strategy or investment product or service. Always consult a qualified professional or your own independent financial professional for personalized advice or investment recommendations tailored to your specific goals, individual situation, and risk tolerance.
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DunhamDC (“DunhamDC”) is a proprietary algorithm of Dunham & Associates Investment Counsel, Inc. (“Dunham”) that seeks to mitigate sequence risk, which poses a threat to an investor's returns due to the timing of withdrawals. The algorithm employs what Dunham considers to be a pragmatic strategy, generally making incremental increases to the equity allocation when global stock market prices decrease and decreasing it when global stock prices increase. This approach is objective, unemotional, and systematic. Rebalancing is initiated based on the investment criteria set forth in the investors application and is further influenced by the DunhamDC algorithm.
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