Managing Risk in Your Retirement Portfolio

By: Tom Betros, CFA, CFP®

A less commonly thought of risk that can impact retirement success has to do with timing and is completely out of our control. Investors that are close to or starting retirement are vulnerable to “sequence of returns risk”. Sequence of returns risk is the unfortunate timing of negative portfolio returns which can have a negative impact on your portfolio’s longevity, and the income you need from it. People just beginning their retirement journey are tasked with replacing their pre-retirement income not just for one year or ten years, but for the rest of their lives which could be up to 30 years or even more. So why can negative returns at this stage of life have such a big impact on your retirement portfolio?

Let’s say at the start of retirement you have $500k and you need to take $50k out at the end of each year for living expenses. Now let’s say your portfolio goes down 20% by the end of the first year, due to unforeseen events, when it’s time to take your first withdrawal. Your portfolio’s value is now $400k. After you take your $50k withdrawal your portfolio value is now $350k. If Year 1 returns were less bad, down 10% for example, after the $50k withdrawal the portfolio value would be $400k. If you look at the final portfolio values after Year 2, there is a $57,500 difference between the Negative and Less Negative portfolios. The difference between the Negative and Slightly Positive portfolios is even more pronounced.

Negative Returns	Year 1 (-20% return)	Year 2 (-5% return)
Starting Portfolio Value	$500,000	$350,000
Ending Portfolio Value	$400,000	$332,500
Withdrawal	$50,000 (12.5% of portfolio)	$50,000 (15% of portfolio)
Final Portfolio Value	$350,000	$282,500

Less Negative Returns	Year 1 (-10% return)	Year 2 (-2.5% return)
Starting Portfolio Value	$500,000	$400,000
Ending Portfolio Value	$450,000	$390,000
Withdrawal	$50,000 (11% of portfolio)	$50,000 (12.8% of portfolio)
Final Portfolio Value	$400,000	$340,000

Slightly Positive Returns	Year 1 (3% return)	Year 2 (3% return)
Starting Portfolio Value	$500,000	$465,000
Ending Portfolio Value	$515,000	$478,950
Withdrawal	$50,000 (9.7% of portfolio)	$50,000 (10.4% of portfolio)
Final Portfolio Value	$465,000	$428,950

This is a hypothetical example meant to illustrate how drawdowns combined with withdrawals can impact portfolio value and is not an indication of how our portfolios would perform in a market drawdown.

As you can see, unfortunate series of negative returns, whether market-related or idiosyncratic, can cause you to deplete assets faster when you are also taking withdrawals. Taking a withdrawal during a drawdown has the effect of selling low, when you typically don’t want to sell, limiting future upside which may reduce the portfolio’s longevity. It’s easy to lose sight as markets have marched higher over the last several years, but investors must be alert and prepared, especially if they are soon-to-be or recently retired.

Managing risk in retirement starts with understanding how your portfolio is structured and whether it is protected against unexpected market events. Importantly, “protected” does not mean going to cash or other ultra-conservative investments with your entire portfolio, rather, it means having an appropriate asset allocation for your withdrawal needs and risk tolerance to a point where a sudden market event would not severely impact your retirement goals. In fact, going to cash could impact asset longevity even more.

When thinking about sequence of returns risk, two scenarios come to mind that deserve extra caution.

Scenario 1: Employer Stock/Concentrated position(s)

A concentrated position is typically considered to make up at least 10% of your overall portfolio. Investors can build up concentrated stock positions through their employer or through their own investing endeavors. Oftentimes employers offer stock to employees through performance bonuses, stock purchase plans, restricted stock units, etc. These forms of compensation are usually a means of incentivizing and retaining employees. Whether you acquire the stock through your employer or on your own, as years go on and shares are accumulated, these shares may make up a large proportion of wealth. This is where caution must be exercised. It is easy to become attached to your portfolio holdings because of the wealth they have helped you amass. It is only normal to think this way, but it is also important to remember that past performance is not an indicator of future results. Stocks can go down. Great companies can go through rough stretches. New companies can emerge that are competitive with yours. Unforeseen events can impact one sector harder than others.

So why do concentrated stock positions make your portfolio so vulnerable? It’s because there are more risks involved. Not only do you have the risk of a broad market decline (which few companies are insulated from), but you also have the risk of your own company underperforming for the various reasons mentioned above (which could happen as the broad markets go up). This is why it is important to take a step back, look at what you have accumulated, be proud of what you have accomplished, think about your goals, and consider taking action if you have any sense of doubt.

Scenario 2: The portfolio is too aggressive for the investor.

Depending on retirement spending needs, an investor may be able to afford to take more risk than the next person because they are overfunded (have more money than they plan on spending) for retirement. But for the investor that is not overfunded or slightly underfunded, that additional risk could hurt if markets struggle in the early retirement years. There are several instances throughout history where markets struggled over a period including the Great Depression (1929-1932), World War II Era (1937-1941), Stagflation of the 70s (1973-1974), the Stock Market Bubble (2000-2002), and the Global Financial Crisis (2007-2009). Investors who had an allocation that fit their risk tolerance and spending needs during these periods likely had more positive outcomes than investors who were over-allocated to risk assets.

So how can you mitigate sequence of returns risk?

• Quantify and prioritize your financial goals (Retirement may not be the only goal).

• Identify where your portfolio may be taking excessive risks.

• Take steps to reduce concentrated positions or equity exposure.

• Consider adding fixed income, which is a more stable asset and is less correlated to the stock market, which usually provides a smoother ride and more downside protection.

• Act on your portfolio well ahead of retirement.

• If you are not sure if your portfolio is taking excessive risks, consider talking to a financial advisor.

The information provided in this blog post is for general informational purposes only and should not be construed as personalized investment advice or a recommendation to buy or sell any security. D’Arcangelo Financial Advisors, LLC does not guarantee the accuracy or completeness of the information presented. Readers should consult with a qualified financial professional before making any investment decisions. Past performance is not indicative of future results. All investments involve risk, including the potential loss of principal.