By Jim DeGaetano, CPA, CFP®, CEPA

As CPAs, we often assist clients in navigating the complexities of retirement planning. Sequence risk is one such area that underscores the importance of proactive planning, especially in the years leading up to retirement. Traditional retirement models often assume a constant or average rate of return, failing to account for the impact of market volatility on withdrawal strategies. It is imperative to educate clients about the risks associated with market timing and withdrawal sequencing.

The sequence of returns risk refers to the phenomenon where the order in which investment returns occur can significantly impact the longevity of a retirement portfolio. Poor investment performance, especially early in retirement, can deplete assets rapidly and jeopardize the sustainability of income throughout retirement. This risk is particularly acute for retirees who start withdrawing funds from their portfolios during market downturns. Unfortunately, despite what economists may say and how sophisticated models have become, nobody knows for certain when the next bear market will occur. It is a fool’s errand to time one’s retirement on an estimation of where we might be in the business cycle. However, it is critically important to plan one’s desired spending level (both needs and wants as well as legacy) with an appropriate distribution strategy that can mitigate running out of money before one runs out of heartbeats.

The major determinant of financial success is behavior. This is important to understand because many of us behave in a manner detrimental to our success. The father of value investing, Benjamin Graham, once stated that “the investor’s chief problem – and even his worst enemy – is likely to be himself.” Recently deceased Daniel Kahneman, Nobel laureate and author of the best- selling book Thinking Fast and Slow, summarized his life’s work into the documented facts that most people think they are better at making decisions than they are. This is why professional guidance is so important when it comes to not running out of money.

First things first: clients must understand that risk and volatility are different. When 20 years away from retirement, a 30% drop in stock value means you buy more shares. When stocks bounce back and revert to the mean, you own more shares at higher prices. This is volatility, which clients can use to their advantage. However, if a client was concluding employment in the next year or two, a 30% drop would mean having to sell shares at lower prices. This is a risk, specifically the risk of not having money when you need it. The protection of principal becomes more important than the growth of the asset as one nears retirement.

Let’s consider a theoretical retiree in the year 2000. This person may have watched a portfolio that held the S&P 500¹ as its sole position drop from $1 million at the start the year to $602,000 on Dec. 31, 2002. The good news is that there are methods clients can consider to offset this market risk as they enter retirement while also allowing a portfolio to be invested and keep pace with the increasing costs of living.

I have included here five strategies to mitigate the sequence risk that comes with converting retirement investments to spendable funds.

Asset Allocation and Diversification

Adopting a balanced and diversified investment strategy can mitigate the impact of market fluctuations on retirement portfolios. Allocating assets across different asset classes, such as equities, bonds, and alternative investments, can provide a cushion against extreme market volatility since not all will go up and down at the same rate.

Dynamic Withdrawal

Dynamic withdrawal strategies adjust withdrawals based on market conditions, which can help preserve portfolio longevity. Look no further than the IRS’s required minimum distribution (RMD) rules. At the end of year, retirees of a certain age must recalculate their RMDs based on the year-end balance divided by the expected life expectancy table. This simple strategy gives the retiree more distributions when the portfolio does well and less when there are hardships. It would also provide greater distributions to a retiree expecting a shorter life than one who is planning for a longer life expectancy.

Bucketing

Creating “buckets” based on time ranges until distribution can be an effective tool. For example, maintaining a cash reserve equivalent to two years of living expenses can provide a buffer during market downturns, and may be considered Bucket 1. This allows retirees to avoid liquidating investments at a loss. Bucket 2 would be cash needs for years 3-7, consisting of securities meant to keep pace with the cost of living. Bucket 3 would hold growth-focused securities for any needs not covered within the first two buckets. As time goes on, the buckets are refilled.

Dividend- or Interest-Only Distributions

Creating a portfolio consisting of dividend-paying stocks or fixed-income securities that cover spending without having to use principal is a sure-fire way to not run out of money. While it would be recommended to combine this strategy with a cash buffer margin of safety, most companies do not reduce dividend payments during recessions, and certain investment screens can be used to mitigate this risk.

As an example, a laddered approach to fixed-income investments can help manage interest rate risk and provide a stable income stream.

Longevity Planning and Insurance Products

Longevity planning options, such as annuities or long-term care insurance, can provide retirees with guaranteed income streams and protection against unforeseen health care costs. These products can serve as a hedge against sequence risk and enhance retirement income security.

The sequence of returns risk can be a significant challenge for retirees and underscores the need for practical retirement planning. CPAs play a vital role in educating clients about the impact of sequence risk on retirement portfolios and implementing strategies to mitigate its effects. By adopting a comprehensive approach to retirement planning that integrates asset allocation, withdrawal strategies, and risk management techniques, we can help clients pursue financial security throughout their retirement years. By addressing sequence risk early in retirement planning, we can help clients safeguard their financial well-being and enjoy a fulfilling retirement lifestyle.

¹ www.macrotrends.net/2526/sp-500-historical-annual-returns

Jim DeGaetano, CPA, CFP®, CEPA, is CEO of Diamond Wealth Advisors and JD Media Company in Carlisle, Pa., and is the author of The Fruitful Retirement and Larry the Bunny Saves his Money. He can be reached at jdegaetano@diamondwealthadvisors.com. Investment advisory services offered through CWM LLC, an SEC registered Investment Advisor.

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^{Statements of fact and opinion are the authors’ responsibility alone and do not imply an opinion on the part of the PICPA's officers or members. The information contained herein does not constitute accounting, legal, or professional advice. For actionable advice, you must engage or consult with a qualified professional.}