Your Life, Simplified

Timing is Everything… When Making Withdrawals (22:18)

November 19, 2019

Sequence of returns risk is the possibility that an investor will have lower returns over time due to withdrawals made during low or negative return years. It may not be something thought about regularly, but it is something that everyone should consider, especially when planning for retirement. We’re joined by Justin Richter of Mariner Wealth Advisors who helps us understand what the overall impacts of taking distributions in a down market can look like over time and explain what strategies can be put in place to mitigate this risk.

Brian Leitner:    Hello and thank you for downloading another episode of Your life, Simplified. My name is Brian Leitner, and I’ll be the host of this podcast. In this episode of Your Life, Simplified, we’re going to talk about sequence of return risks, which is a different type of risk that is in your portfolio and one that may not be addressed enough. Most people may not think about it, but it can be a critical piece of your overall financial planning puzzle and really impact your overall financial plan, especially when you take distributions as you move into retirement. And today our guest is Justin Richter, who is a senior wealth advisor at Mariner Wealth Advisors in our Kansas City office. Justin, thanks for being here.

Justin Richter:   Brian, thank you for having me. Looking forward to it.

Brian: Justin, give us a little bit of background on yourself. If you could tell the audience who you are, what you do, what that looks like.

Justin: Absolutely. I have been with the organization for 6 years, overall have experience within the investment and wealth management business for over 15 years. In addition to managing client’s financial assets and their financial well-being, I’m a key member of Mariner Wealth Advisors’ investment committee.

Brian: Thanks Justin. You know, as we talk about this sequence of returns risk, how would you begin to identify what that is for the audience?

Justin: When we talk about sequence of return risk, it’s something that sounds foreign to many people, but really the gist of it is the timing at which returns occur within your portfolio can have a dramatic impact on the future results of the portfolio. We may talk about having returns of 6% per year when we’re doing financial projections, but we know the reality is not that. There is going to be significant volatility that occurs from year to year. It really does not matter while you’re accumulating capital. But when you start to take distributions or being reliant on the portfolio capital, that timing of when returns occur, especially negative returns, can have, again, a dramatic impact on portfolio performance.

Brian: Justin, just before the show we took a look at a couple of different examples that we ran. And just to give the audience an idea, we took a portfolio, it doesn’t really matter what the dollar number is, maybe it’s $1 million in client one versus $1 million in client two. And in the first example that individual had their first few years of positive returns and it ended up 25 years later that they had a great deal more than the $2 million and everything was great. But in client two’s portfolio, they experienced negative returns in the first three years, and they ended up running out of money before that same time period. To your point, the sequence of their returns and when you have those returns could have a dramatic impact on your overall portfolio.

Justin: Timing is everything.

Brian: Timing is everything. You just mentioned from an accumulation perspective, and we think about as people are saving money, they’re still working. The sequence of returns may not obviously have a huge impact, because you’re not living off of those funds. But the distribution phase is where they have the biggest impact. When is there dramatic impact of sequence of returns, from what you’ve seen?

Justin: The day of retirement. As soon as something can happen in the early years when you’re starting to withdraw from capital, that’s when you’re going to see the most significant impact. When you’re in the accumulation phase, that downside volatility is actually a benefit for you. At that point, you can actually add capital to the portfolio, but on the opposite side, when you’re in retirement, you’re reliant on those funds. The opposite happens. Dollars taken out don’t have the ability to recover, when the market usually recovers, whether that’s six, 12 or 24 months down the road.

Brian: And thinking about that psychologically, you’ve saved your entire career, you’re about ready to live the good life, the day you retire, boom – the 20% correction, whatever that looks like. I mean, that’s dramatic, not only financially, but just psychologically, because I just took myself out of the workforce. Right? You work with a lot of clients. I mean, how do you mitigate that? How do you navigate that with folks?

Justin: Yeah, I think really the number one issue is, for an advisor, be aware of it and educate the client as early as possible on what sequence of return risk is and how to avoid it. So when we bring on a new client to the firm, there is a lot of information that we go through, and it’s important to go through the details. First and foremost, of course we’re going to walk through with that client their goals and objectives and really prioritize those goals and objectives as we look out over the short term, medium term and long term. As we’re going through the details, it really is important to have the inputs for that plan as detailed as possible, especially the cash flow analysis. So, as an example as we’re going through that, the most important part of that cash flow analysis is really getting a good handle on what spending is currently and what it’s likely going to look like in the future.

When we go through that process with our clients, we try to break down those expenses into tiers, where ultimately we are going through the process of separating what our core or fixed expenses would be, whether it’s a mortgage, a payment or rent, that could be utilities, car payments, things that you just absolutely have to pay. Separating that from discretionary expenses, whether that’s eating out, travel, other things that you can live without for a period of time. You may not be happy about it, but if it’s a dire situation or an uncomfortable situation, those are things that can be adjusted. And a third category that not a lot of people think about when they’re breaking off expenses and cash flows is gifting, whether that be charitable gifts or gifting to kids and grandkids. And that can also include, say, 529 plans for those kids or grandkids. So, getting an idea of really what those expenses are and starting to categorize in your mind the importance of those given the expenses.

Brian: I appreciate the way you categorize those and broke those out. But I think listeners greatly appreciate is the fact that you didn’t use the word budget. Because nobody likes to hear the word budget, right?

Justin: Yes. So, beyond the cash flow components, the other piece that we take very seriously is looking at the assumptions that are going into the plan. The plan is only as good as the assumption in data that goes into it. One that I think people tend to not spend enough time on is thinking about the expected return data. Most planning software will use some form of linear expectation of return. What I mean by that is that, if the given return assumption is going to be, whether it’s 6% per year or 5% per year, 7% per year, whatever that number is, it’s expected in the plan to occur each and every year. We know that that’s not reality

Brian: Because otherwise it would always look good, right?

Justin: Yes, absolutely. So we know that’s not reality. It’s important as we’re looking at the portfolio and trying to do projections for the retirement planning, to really stress test the actual returns that the investor might experience going forward. Again, rather than expecting 6% per year, we look at the portfolio composition, what has been the historical volatility of that portfolio, and then run the Monte Carlo analysis to run thousands of iterations of that potential volatility pattern to see what ultimately happened in that plan. Really, what is the ultimate probability of success that all those objectives and goals that we talked about earlier, actually get met.

Brian: With random rates of return and standard deviation and interest rates. The idea is to depict the more realistic scenario as opposed to linear.

Justin: Absolutely. That helps us to really get into more detail of what could happen rather than maybe showing a rosy scenario of that constant return pattern. From that, it can show us if there are potentially shortfalls. If that probability of success is not as high as we’d like to see it, we can start to have the conversation early on about how do we fix it, how do we avoid it? Really the primary, it comes back to then the cash flow conversation where we are looking again at those discretionary expenses. If we get into a challenging environment, right when retirement happens or whether it’s five years into retirement, how can we make adjustments and cut back on some of those non-necessary items?

Brian: What I love about that approach is, you really are stress testing. You’re looking at it from a couple of different scenarios. From a linear perspective, you can be great, and I think there are a lot of folks out there who just say, you know, look at the 6%, 7% a year rate of return cause that’s the good ballpark. You know, I’m sure the listeners are going to make a decision that, “Hey, this is the day I’m going to retire. I want to make sure that I truly understand what’s going to take place and what the risks are before I go ahead and do this.” So, if you could see somebody who is failing, to your point, you can go in and look at the cash flows, look at the expenses and say, “Hey, we’ve got to make some changes.” I think that gives everybody peace of mind. Right?

Justin: Absolutely. The expenses are one side of that. Things that can be delayed, whether it’s large purchases, new cars, looking at gifting. On the other side is income. That’s the other thing that hopefully is within the control of the individual. Someone is still currently working, and you know that there’s a potential for a gap. It could provide some motivation to add an extra year or two of full-time work to build a larger asset base so that the sequence of return doesn’t matter as much in that planning process. Also having contingency plans for maybe transitioning to part-time work. If the ultimate goal was to retire at 65, perhaps we can put in scenarios where there’s part-time, whether it’s 20, 30 hours a week, that would occur for another two, three years after that period to provide additional cushion within that plan.

Brian: Those are all great points. I really liked and appreciated what you said about the fact that you may have an expense, but you could always push that back. If you were going to remodel the kitchen or take that vacation, taking it in year one versus year five, if the portfolio is growing, the plan may allow for that expense to be had in year five versus year one. It doesn’t mean that they can’t do it, but just walking them through the various scenarios. I think that’s great.

Justin: In addition to looking at that cash flow approach, another approach that we’ll tend to look at from time to time, that many listeners may have heard of is the 4% rule. For those who aren’t aware of what that is, the 4% rule is looking at spending 4% of your asset value each and every year. That way if the market’s up, you’re getting a raise of what you can take out of the portfolio and spend. If the market is down, you need to forcefully cut back so you’re only taking that 4% from the portfolio.

Brian: The most basic example, if somebody has $1 million, they can take out say $40,000 in that example, and that’s in addition to whatever they might receive in terms of outside income, like Social Security or pension or something of that size? Correct?

Justin: Correct. So that’s one plan. Although, there are some challenges to that. Can a person be disciplined enough to actually reduce spending when that 4% becomes a lower number than what it has been in past years due to market loss? The other challenge may be, historically if you’ve had a stronger return, say 6 to 7% from a balanced portfolio, we’ve obviously had a good run in the markets over the last 10 years. We’re headed into a more maybe more challenged environment as we look forward over the next 10 to 20 years. So maybe that 6 to 7% return is only 5 to 6 or maybe lower. If you’re looking at trying to maintain the purchasing power of the portfolio, if you’re taking out 4% and we have 2% inflation and you have another tax and other costs, you’re moving backward in a hurry in that scenario. In that situation, the 4% rule maybe coming more like a 3% rule. If you were to look forward over the course of the next 10 to 20 years.

Brian: And this 4% rule is for our listeners who don’t know, it’s well-documented. It’s widely used in the business. Nothing’s perfect. My question for you is, if I’m retiring, let’s say at 65 or 70, whatever that age is at 4%, and I know I have X amount of years to go. As I age, so maybe I’m now 80 years old, does 4% still make sense? Or if the market’s grown, can I take out more? What does that look like?

Justin: It really comes back to the goals and objectives of if your objective is to try to leave as much to heirs or charity, maybe you leave it at that 4%, but if there’s not a significant goal to leave a great amount of capital to other parties, then absolutely it makes sense as your life horizon shortens, that you can take a larger percentage of the portfolio, not necessarily have to worry as much about outliving your capital.

Brian: Make the last years as your best.

Justin: Exactly.

Brian: What are the other ways that, when you talk to clients about how to mitigate this? Because when everybody’s putting money away and it’s a long term, I don’t need to worry about it. Well now I’m about to retire, I’ve just retired, and I see the volatility that’s taking place even right now. I mean, what is another strategy that you leverage with folks?

Justin: Yes. Another strategy that is relatively common is to look at what would be called a bucket approach. In a bucket approach, you break your portfolios or accounts into, as it sounds, different buckets for different purposes. Those purposes that we’re looking at, short-term spending needs, intermediate needs, and then long-term growth potential. So, when we walk through that type of situation, your short-term bucket will be comprised mostly of cash and equivalents. In most cases, depending on the individual, that underlying cash equivalents will be equivalent to whether it’s six months of living expenses, 12 months of living expenses, sometimes more depending on the comfort level of that individual of how much they want to have readily available and not have to be forced to sell assets at an inopportune time if indeed the market does correct.

Brian: And when you say cash equivalents, CDs, money market markets, things of that nature?

Justin: Correct. Things that are liquid with very limited volatility. So, that would be a potential for short term some clients though, especially in a low yield environment like we have been for the last 10 years and likely will continue to be for a long period of time, don’t want to have too large of a cash balance that’s earning close to nothing. In those cases, what we’ve done for clients is advise them to utilize their taxable portfolios, with either a margin or a securities line of credit. So, that securities line of credit or margin would basically allow them to borrow from their portfolio, if they did have a significant need that occurred at a time where it was in opportune to have to sell portfolio security. That way they can stay more fully invested. They don’t have that what we’d call cash drag and reducing the overall portfolio rate of return.

And then that way if they’re comfortable with it, they can utilize that line. And then whether it’s six, 12 or 24 months later when the market environment has recovered, at that point in time, they can solve the underlying securities in the portfolio. That would be needed to pay off that line of credit.

Brian: Sure. That makes a lot of sense to have that type of optionality.

Justin: Yes. It definitely provides options, although some people are just against having any sort of debt or debt-like instrument. It’s not for everybody, but it’s another potential tool in the toolbox so to speak, to handle that bucket approach for short term. The next would be looking at medium term. And for that we want to have rolling capital available, that’s providing liquidity. That’s again, not going to force us to sell assets. One area that tends to fill that bucket is a diversified bond ladder. Having maturities that are happening either on a monthly basis or a quarterly basis, that over the course of the year will provide enough income or distributions that will be covering the spending needs for that year. That we were getting bonds that over a period of time or gradually providing cash flow and hopefully some higher return. Although again, in a low yield environment, you’re not getting a great return from that environment right now.

Brian: Just to make sure everyone understands the idea of the bond ladder. It’s not one individual bond, it’s a series of bonds with different maturities. So effectively you’re almost replicating a paycheck to some degree, is that an accurate statement?

Justin: Yes, that is, that is correct. Another asset that could be within that bucket would be other liquid or lower volatility assets. Those would be the types of things that would have a higher expected return than core fixed income or that bond ladder that have that minimal volatility. If you did need to sell those assets for an unforeseen situation, you’d have the ability to do so. Then as we look to the long term, we can separate out truly growth-based assets that are there, whether it be equities, private assets or real estate that are there to grow for the long term. That way if you have those separated out into separate buckets or accounts, it doesn’t necessarily matter if you have fluctuation in your medium- or long-term buckets. As long as you have enough capital in that short- term bucket to cover expenditures, you can rest easy knowing that the others will eventually recover.

Brian: I wouldn’t even look at the growth bucket because I know that’s going to be more volatile and that might keep me up at night versus the first or potentially the second bucket. I think that’s a very interesting strategy. I appreciate sharing that with us. And then when you think about, maybe just the overall asset allocation, somebody’s entire financial situation, all of their assets. We talked about a couple of different things as it relates to overall risk tolerance. We could also factor in what’s known as risk capacity. And as we think about the sequence of returns, so how does the overall asset allocation play a role in this?

Justin: Really, for any of our clients, having proper asset allocation is very important. It definitely plays a role when we get into a sequence of returns. Especially in an environment where we’ve been in the last 10 years where we’ve had an equity market that’s done nothing but appreciate, with a little bit of volatility here and there. We can tend to have an over allocation that occurs whether there hasn’t been proper rebalancing or there just been a flight to assets that have overperformed. It can create imbalances in the overall portfolio, and maybe create a situation where there’s too much risk being taken in the portfolio than there should be. It comes back to our stress testing of that specific portfolio to make sure that one’s risk tolerance truly matches how the portfolio is currently constructed.

For that, we can take a look at the portfolio construction as it is and stress test to prior stressful periods. Whether that’s looking at what would this portfolio have done if we were to see another 2008, 2009 environment, or what would it do if we’re in a stagnated inflation environment, yield environment. And that can be a good indicator to be able to show, can I stomach what ultimately would happen in that type of environment. It’s healthy for all clients to do as a reminder, but especially for those who are nearing or in retirement who can’t really take that more significant downside hit in the market.

Brian: That’s very helpful. Just to recap; as ways to mitigate this risk and we think of the spending itself and again, it doesn’t matter whether your portfolio is half a million dollars, $1 million or $10 million, if someone’s spending way too much and it’s going to impact them over the long term, and they can see what that impact is, especially with this sequence of returns risk, that’s obviously important. The 4% rule. We know it’s kind of the golden rule that’s out there, but everything’s a little bit different. People are different. Times will be different. And then even inside of that you have different inflationary factors. For example, the health care spend that you have may increase a lot greater or at a much faster rate than a different expenditure and so forth. And there are other things take into account. Really appreciate the bucket approach and what that looks like and breaking it out and truly simplifying it for folks. And then your overall asset allocation, which is key to your point and making sure we’re factoring in all of the different variety of risks. Thanks for helping us with that topic. Before I let you go, we ask all of our guests the same question. And the question is, what’s the worst financial mistake you’ve ever made?

Justin: I think it’s market timing. It’s one of those things we talk about to our clients, to not try to time the market. Sometimes as advisors, we don’t follow our same preaching

Brian: Or we learned back in the day and now we’re better off for it.

Justin: Exactly. I think ] I’ve learned, and it’s one when we talk about this topic, for sequence of returns, some of the more challenging situations I’ve seen clients go through as making that market timing call at the wrong time. And in most cases, it’s getting too conservative at the wrong time when you’ve already experienced that decline and it continues to create a more challenging environment going forward.

Brian: Well, I appreciate you sharing it and having you here. Everyone, thanks for listening to the show today. You have questions, ideas, comments for the show, please go ahead and email them in at podcast@marinerwealthadvisors.com. Thanks again for listening.

The views expressed are for commentary purposes only and do not take into account any individual personal, financial, or tax considerations. It is not intended to be personal legal or investment advice or a solicitation to buy or sell any security or engage in a particular investment strategy.

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