Understanding and Managing the Sequence of Returns Can Help Meet Retirement Goals

 

ENVESTNET PRACTICE MANAGEMENT SERIES

»

Visit www.envestnet.com/retirementsolutions »

After years and decades of planning, saving and working, an important goal has been reached. Your clients are ready to retire.

Or are they? Perhaps you will have to help them deal with anxieties that other boomers are facing – anxieties that are both practical and emotional.

Rather than fear the unknown, it is more useful to focus on factors that are within your clients’ control. The amount of discretionary income that is appropriate and the principle reduction rate as well as the level of risk tolerance are factors that can be assessed and managed. In addition, the order of asset liquidation to meet income needs can also be managed.

Retirement planning is loaded with uncertainties. Outside forces – longevity, future healthcare costs, inflation and overall market returns – are unpredictable and uncontrollable.

Modern portfolio theory recognizes that, although over long periods of time stocks increase in price, shorter time periods are unpredictable and often negative. So, individuals who are looking at holding a stock portfolio during retirement can be uncomfortable with the prospect of losing their equity positions. They no longer have the luxury of time to smooth out investment cycles.

The Sequence of Returns Dilemma

Year-to-year market volatility becomes a significant issue in retirement. Figure 2 shows the dramatic difference that timing of stock market returns can make for retirees who are making annual withdrawals from their portfolio.*

Beginning with $1 million in 1989, withdrawing $50,000 in the first year and indexed for an approximate 3% annual inflation rate, the 100% equity investor’s retirement fund has grown to $3.1 million in 2008.

However, if the S&P 500 annual returns were reversed, year-to-year returns in the initial withdrawal returns are generally lower. The investor, following the same inflation-indexed 5% withdrawal rate, would be left with a mere $235,103 at the end of the twentieth year.

The difference between Figure 2 and Figure 4 is that the investor has diversified into a 60/40 portfolio, maintaining a cash/fixed income segment to protect from the need to sell equities in a down market. Using the 20-year S&P 500 actual annual returns, the diversified investor’s initial $1 million grows to $2.6 million. Under the less-favorable hypothetically-reversed 20-year returns, the portfolio outperforms Figure 2’s 100% equity portfolio, ending with a balance of $822,768.

The benefits of maintaining a balanced portfolio, which anticipates and allows for volatile year-to-year equity markets, is clear. Although balanced investors ending $2.6 million falls short of the $3.1 million gained by all equity investors, the downside comparison leaves diversified investors with close to $500,000 more than the all-equity investors.

Focus on What You Can Control

Rather than fear the unknown, it is more useful to focus on factors that are within your clients’ control. The amount of discretionary income that is appropriate and the principle reduction rate as well as the level of risk tolerance are factors that can be assessed and managed. In addition, the order of asset liquidation to meet income needs can also be managed.

To preserve growth potential, equity assets should be allowed to weather the volatility of economic cycles and stock markets. Once the equities are sold, without a fresh injection of capital, it is virtually impossible to capture the growth potential that stocks provide.

With time-segmented distribution, you can offer a decision-making structure that seeks to address the most common pre-retirement fears. When you employ the strategy, you will separate the 25-plus year retirement time span into manageable components or segments. As you look at each segment and assign it a function – income-generating, mid-term safety or long-term growth, for example – that supports retirement, you can show clients how they have potential to meet their retirement needs.

While time-segmented distribution offers many positive options, it is important to note what it does not do. The strategy does not mean that portfolios will outperform. It does, however, provide an opportunity to participate in long-term market growth while still enjoying a reliable income in retirement.

Perhaps most important, as you present the strategy to your retiree clients, they will recognize investing concepts you have discussed with them. That is because it builds on concepts that your clients may already be familiar with -- risk tolerance, a long-term investment perspective and the benefits of asset allocation.

Presenting Time-Segmented Distribution to Your Clients

If you believe time-segmented distribution makes sense for your clients, here are suggestions for discussing the strategy with current and potential retirees.

1-Start with Basic Assumptions

Most of the ideas behind time-segmented distribution are not revolutionary. They are structured for individuals and families who worry about how to balance income and growth in retirement.

· Markets are volatile in the mid- and short-run, but over long periods of time they grow and return to the mean. Look at the Dow throughout the 20th and early 21st centuries; smoothed out over time, it is a consistent upward slope, reflecting the growth of the U.S. economy.

· No strategy can entirely eliminate risk, but so far asset allocation has historically established itself as a solid solution. In a sense, time-segmented distribution works in tandem with asset allocation over the full time span of retirement. That approach can help seek a consistent, reliable income as well as an opportunity to participate in market growth.

· Withdrawal rates can be determined based on factors that are in your client’s control: discretionary income and the principle reduction rate, how much risk you take, which assets are liquidated first. A traditional 4 – 6% withdrawal rate can be employed as part of the process.

2-Offer an Example

Consider the example of a retired couple with $1 million in funds, with 60% in equity and 40% in fixed income investments. To maintain that consistent allocation, taking 4% a year, the couple would take $24,000 from stocks and $16,000 from fixed income. But what if it is a year when the market is down? By continuing to take the $24,000 from equities in that down year, the equity asset base becomes depleted sooner than necessary; the growth component is missing, and it becomes more difficult to meet income goals in future years.

3-Briefly, Explain How it Works

A time-segmented distribution strategy means creating separate portfolios or segments for these clients so they would not be drawing down equity assets prematurely. The segments are designed to span the risk spectrum and the retiree’s potential lifetime.

4-Discuss Risk Tolerance

The concept of risk tolerance is a cornerstone of time-segmented distribution. Since you are looking at risk through the lens of this new strategy, it is valuable to take time to revisit the client’s attitudes toward risk.

5-Address Additional Issues

You can use the Checklist either in its entirety or to adapt approaches that fit your style. Here are a few ideas for taking advantage of the Checklist:Once you feel that your client is interested in moving forward with the strategy, there are a number of supporting issues to cover. For example:

· Recognize that time-segmented distribution does not mean the assets go on auto-pilot. As segment target levels are reached or other circumstances change, the overall portfolio should be rebalanced. When segment levels are above the target, the excess can be moved into a more appropriate segment.

· Just as ongoing reviews are part of the retirement planning years, it is important to continue to meet regularly with your clients to fine tune the retirement income strategy.

· Allow for unplanned spending, including emergency repairs, family situations, or higher than anticipated health costs.

How does PlanHorizon help?

Without an advanced technology, it would be nearly impossible to tailor a set of individual portfolios that fit the principles of time-segmented distribution.

Envestnet’s PlanHorizon can help identify appropriate allocations and targets for accumulation within individual segments. Although each segment is earmarked for a select number of years, the portfolio can be managed as a single unit. If one segment is performing better than expected, excess assets can be moved to fund other segments and help them achieve their targets.

Consider these features:

· The purpose of PlanHorizon is to help advisors build, implement, and manage a portfolio of retirement assets that fit a time-segmented distribution strategy.

· Capital market assumptions can be used to determine allocations and target accumulations.

· Settings can be customized.

· Reports show progress toward goals for each segment and make adjustments to the portfolio as needed to manage toward the target objectives.

· An optional guaranteed income segment can be built in to allow for a product with guaranteed living benefits or lifetime annuitization.

· Each segment of the time-segmented distribution retirement portfolio is managed individually, but the investments in each portfolio work together to supply income throughout retirement.

For more information, read the PlanHorizon brochure.

Objective Analysis

Several studies have tested the strategy with encouraging results.

The August 2008 issue of the Journal of Financial Planning reported on an income-harvesting study that not only looked at interest rate assumptions on assets it also emphasized taking advantage of the volatility of the equity markets in a retirement income solution model. Using data from 1927 to 2004, the study separated accounts into segments in a manner similar to that discussed earlier in this article. The study concluded that the process could produce a “higher income stream than other conventional methods.”**

In another study, several other withdrawal methods were compared with the time-segmented distribution model using back-testing data. In the hypothetical testing, the time-segmented strategy produced the “highest probability of success at the highest withdrawal rate.”***

An Opportunity for Your Clients

Regardless of wealth level, economic events of the past two years have heightened retirement fears for baby boomers. You have an opportunity to provide a plan with a structure that addresses those emotions and has a rationale that speaks to issues of inflation and market volatility.

Take the time to get comfortable with the time-segmented distribution strategy. Make sure your clients understand this concept and how you can help them plan for all seasons of their retirement.

---

 

* www.thornburginvestments.com/research/road/ror_sequencing.asp

** Hung, Angela et al, Investor and Industry Perspectives on Investment Advisers and Broker-Dealers. RAND Corporation, 2008.Parker, Zachary S., 2008. “Income-Harvesting Strategy: Achieving Inflation-Adjusted Income from a Lump-Sum Asset,” Journal of Financial Planning, August 2008, pages 52-61.

*** “Capturing the Income Distribution Opportunity,” Securities America, May 2007

 

This article is provided for informational and educational purposes only. It is not intended as and should not be used to provide investment advice and is not an offer to sell a security or a solicitation of an offer, or a recommendation, to buy a security. All investments carry a certain risk and there is no assurance that an investment will provide positive performance over any period of time. Investment decisions should always be made based on the investor's specific financial needs and objectives, goals, time horizon, and risk tolerance. The statements contained herein are based solely upon the opinions of Envestnet. All opinions and views constitute our judgments as of the date of writing and are subject to change at any time without notice. Neither Envestnet nor its representatives render tax, accounting or legal advice. Past performance is not a guarantee of future results.

FOR FINANCIAL ADVISOR USE ONLY.