{"id":93370,"date":"2019-10-29T09:00:12","date_gmt":"2019-10-29T15:00:12","guid":{"rendered":"https:\/\/www.biggerpockets.com\/renewsblog\/?p=93370"},"modified":"2024-02-13T18:34:55","modified_gmt":"2024-02-14T01:34:55","slug":"sequence-risk-retirement","status":"publish","type":"post","link":"https:\/\/www.biggerpockets.com\/blog\/sequence-risk-retirement","title":{"rendered":"Sequence Risk: How to Ensure Your Nest Egg Doesn’t Go Belly Up Before You Do"},"content":{"rendered":"

\u201cWhat happens if the stock market crashes right after I retire?\u201d<\/p>\n

My mother is nearing retirement, so she and my stepfather have started meeting with financial advisors to form a firm plan for their retirement.<\/p>\n

Not surprisingly, one of the issues that\u2019s come up is \u201csequence risk\u201d or \u201csequence of return risk.\u201d It\u2019s a big concern for new retirees, or at least it should be (especially in today\u2019s aging bull market).<\/p>\n

Fortunately, new retirees have plenty of options!<\/p>\n

Here\u2019s what you need to know about sequence risk, whether you\u2019re 30 years or 30 days away from retiring.<\/p>\n

What Is Sequence of Return Risk?<\/h2>\n

Sequence risk is the risk that the market (usually the stock market, but technically any market you\u2019re invested in) will crash within the first few years of your retirement.<\/p>\n

What\u2019s the big deal? Why is the timing so important?<\/p>\n

Two reasons. First, if your retirement is based on stocks and the stock market crashes, then each individual share that you own will be worth much less. That means you\u2019ll have to sell many more shares to achieve the same income.<\/p>\n

Let\u2019s say you\u2019re selling $50,000 worth of stocks each year in your retirement. If the market crashes by 30%, you\u2019ll need to sell 30% more stocks than you did before the crash, to pull that same $50,000 out for your expenses.<\/p>\n

So, you\u2019re burning through your portfolio 30% faster. And not just during the crash, either\u2014you\u2019ll be burning through your stocks faster for years, until the market eventually recovers to the pre-crash level.<\/p>\n

That could be over a decade. The Nasdaq took 15 years to recover after the crash of the early 2000s!<\/p>\n

The second reason is that the crash is all downside for you since you\u2019re only selling, not buying. You won\u2019t benefit from the crash as a “discount sale on stocks” because you\u2019re not buying when stocks are dirt cheap.<\/p>\n

Two Portfolios to Illustrate Sequence Risk<\/h2>\n

Visual learner? Or just like math?<\/p>\n

Cool. (See, kids? Math can be cool!)<\/p>\n

Cindy has $100,000 invested in the stock market. In Scenario 1, the stock market crashes the first year she retires, dropping 29%. It then bounces around over the next 20 years, as it is wont to do.<\/p>\n

In Scenario 2, the first 10 years\u2019 returns are reversed, so that nasty 29% stock market crash hits Cindy on her 10th<\/sup> year, rather than her first.<\/p>\n

The differences end there. In both scenarios, Cindy withdraws $6,000\/year. In both scenarios, Cindy earns an average return of 5.3%.<\/p>\n

After 20 years, Cindy is broke in Scenario 1, but is still going strong in Scenario 2:<\/p>\n

\"\"<\/p>\n

If you want to look at the data I used, here\u2019s a table:<\/p>\n\n\n\n\n\n\n\n\n\n\n\n\n\n\n\n\n\n\n\n\n\n\n\n\n\n
Year<\/td>\nScenario 1 Return<\/td>\nScenario 1 Balance<\/td>\nScenario 2 Return<\/td>\nScenario 2 Balance<\/td>\n<\/tr>\n
0<\/td>\n<\/td>\n$100,000<\/td>\n<\/td>\n$100,000<\/td>\n<\/tr>\n
1<\/td>\n-29%<\/td>\n$66,740<\/td>\n28%<\/td>\n$120,320<\/td>\n<\/tr>\n
2<\/td>\n8%<\/td>\n$65,599<\/td>\n9%<\/td>\n$124,609<\/td>\n<\/tr>\n
3<\/td>\n-16%<\/td>\n$50,063<\/td>\n12%<\/td>\n$132,842<\/td>\n<\/tr>\n
4<\/td>\n14%<\/td>\n$50,232<\/td>\n9%<\/td>\n$138,258<\/td>\n<\/tr>\n
5<\/td>\n8%<\/td>\n$47,771<\/td>\n10%<\/td>\n$145,483<\/td>\n<\/tr>\n
6<\/td>\n10%<\/td>\n$45,948<\/td>\n8%<\/td>\n$150,642<\/td>\n<\/tr>\n
7<\/td>\n9%<\/td>\n$43,543<\/td>\n14%<\/td>\n$164,892<\/td>\n<\/tr>\n
8<\/td>\n12%<\/td>\n$42,048<\/td>\n-16%<\/td>\n$133,469<\/td>\n<\/tr>\n
9<\/td>\n9%<\/td>\n$39,293<\/td>\n8%<\/td>\n$137,667<\/td>\n<\/tr>\n
10<\/td>\n28%<\/td>\n$42,615<\/td>\n-29%<\/td>\n$93,483<\/td>\n<\/tr>\n
11<\/td>\n12%<\/td>\n$41,008<\/td>\n12%<\/td>\n$97,981<\/td>\n<\/tr>\n
12<\/td>\n10%<\/td>\n$38,509<\/td>\n10%<\/td>\n$101,180<\/td>\n<\/tr>\n
13<\/td>\n9%<\/td>\n$35,435<\/td>\n9%<\/td>\n$103,746<\/td>\n<\/tr>\n
14<\/td>\n-5%<\/td>\n$27,963<\/td>\n-5%<\/td>\n$92,858<\/td>\n<\/tr>\n
15<\/td>\n-11%<\/td>\n$19,547<\/td>\n-11%<\/td>\n$77,304<\/td>\n<\/tr>\n
16<\/td>\n23%<\/td>\n$16,663<\/td>\n23%<\/td>\n$87,704<\/td>\n<\/tr>\n
17<\/td>\n13%<\/td>\n$12,049<\/td>\n13%<\/td>\n$92,325<\/td>\n<\/tr>\n
18<\/td>\n18%<\/td>\n$7,138<\/td>\n18%<\/td>\n$101,864<\/td>\n<\/tr>\n
19<\/td>\n-16%<\/td>\n$956<\/td>\n-16%<\/td>\n$80,526<\/td>\n<\/tr>\n
20<\/td>\n12%<\/td>\n-$5,649<\/td>\n12%<\/td>\n$83,469<\/td>\n<\/tr>\n
Avg. Return:<\/td>\n5.30%<\/td>\n<\/td>\n5.30%<\/td>\n<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n

 <\/p>\n

Before you say, \u201cCindy should have followed the 4% Rule<\/a>\u201d or \u201c5.3% is on the low side historically for stock market returns,\u201d or \u201cHow does she live on $6,000\/year?\u201d, know that I\u2019m illustrating a point here, gosh darn it!<\/p>\n

Sequence risk\u2014the order in which you earn your returns\u2014matters.<\/p>\n

The Typical Answers from Financial Advisors<\/h2>\n

If we had a standard-issue financial advisor in the room, the first thing she would say is, \u201cThis is why we talk about asset allocation with retirees. Cindy should have had more of her portfolio in bonds.\u201d<\/p>\n

About now is when they cart out the \u201cRule of 100,\u201d where they say you subtract your age from 100, and that\u2019s what percentage of your portfolio should be in stocks.<\/p>\n

Except I don\u2019t like the Rule of 100. The go-to investment that financial advisors say retirees should focus on is bonds, but bonds\u2019 returns have just plain sucked for, like, 20 years now. (How\u2019s that for scientific?)<\/p>\n

Alright, alright, here\u2019s a chart on long-term U.S. Treasury yields for you:<\/p>\n

\"\"<\/p>\n

And sure, you could invest in higher-risk, higher-yield bonds. But as you scale the risk-yield ladder, you quickly reach a point of \u201cI thought the whole point of switching to bonds was to minimize my risk?\u201d<\/p>\n

One answer that your financial advisor might put forth is to make sure you\u2019re taking advantage of Roth IRAs. The proceeds are tax-free, so you won\u2019t have to pull out extra money for income taxes. They also don\u2019t force you to start withdrawing funds when you reach 70\u00bd (like regular IRAs do), so you can give them a little longer to grow and avoid selling in a down market.<\/p>\n

Two Other Ideas from Financial Advisors<\/h2>\n

One financial advisor gave my mother a different idea. He proposed that she and my stepfather pull several years\u2019 worth of expenses out before retiring and set them aside in cash.<\/p>\n

That way, if the stock market crashes within the first few years of their retirement, they don\u2019t have to sell during the crash.<\/p>\n

They\u2019ll take a hit on inflation, of course. They\u2019ll also incur opportunity costs\u2014they\u2019ll lose the potential returns they would have earned if that money had been out working for them.<\/p>\n

There are other options for this strategy as well that mitigate these downsides. One is putting the cash in a money market account. A second is investing in dependable, safe assets like those U.S. Treasury notes we talked about above.<\/p>\n

Another idea is that retirees could use trailing stop orders to limit their losses in the event of a crash. If you\u2019re not a nerd about this stuff, a trailing stop order<\/a> sets a certain amount that your investment could decline by before triggering an order to sell. But unlike traditional stop orders, they follow (trail) the equity\u2019s value upward, and use its highest value as the reference point.<\/p>\n

For example, you buy a mutual fund and set a trailing stop order of 5%. The fund rises and rises and rises\u2014then a panic hits the market. When the selloff reaches 5% below its recent high, your fund shares automatically sell. You lose 5%, instead of the 35% that the fund ends up dropping before bottoming out.<\/p>\n

Where Do Rental Properties Fit In?<\/h2>\n

Get to the real estate already!<\/p>\n

Rental properties create passive income, which is, of course, awesome. Aside from helping you reach that 7-figure nest egg faster<\/a>, rental properties\u2019 cash flow and income are not tied at all to the stock market.<\/p>\n

Let\u2019s say Cindy earns half her retirement income from rental properties, and the other half comes from selling stocks. First, her stock portfolio draws down at half the pace, which is great.<\/p>\n

But second, Cindy has some control over her cash flow. Landlords\u2019 cash flow is about taking long-term averages of expenses, not what happens in a \u201ctypical\u201d month. For instance, a $5,000 new roof is averaged into the monthly cash flow as part of CapEx.<\/p>\n

Consider this, though\u2014Cindy knows one of her rentals needs a new roof soon. Another leak sprouts, and she has a choice: Does she shell out the $5,000 to replace the roof, or does she spend $300 to patch it?<\/p>\n

If the stock market just crashed, it\u2019s a bad time for Cindy to take on that $5,000 cost. Sure, she\u2019s been budgeting for CapEx and repairs, so she has funds set aside for these sorts of costs. But she knows it\u2019s a bad time for her stock portfolio and wants to stay as liquid as possible right now.<\/p>\n

So, she patches the roof, and buys herself another 18 months.<\/p>\n

Or imagine she has renters who are thinking about moving. Cindy knows the turnover will leave her with at least one or two months\u2019 vacancy, and the property will need new carpets and paint to be marketable to a new tenant. All said, that turnover will cost her $5,000.<\/p>\n

What does she do? She persuades the renter to stay by waiving the annual rent increase that year or offering them some other incentive to stay another year.<\/p>\n

These maneuvers won\u2019t change the long-term averages of her costs\u2014vacancies, turnovers, maintenance, repairs will all come due sooner or later. But Cindy has some leeway over when she incurs the costs, and she knows that when the stock market has just crashed, she wants to lean as heavily as possible on her rental income and avoid selling any stocks if possible.<\/p>\n

\"pick-stocks\"<\/p>\n

Real Estate as a Counterweight to Stocks<\/h2>\n

Some years, stocks will perform well for you. Likewise with your rental properties; with all your investments, you\u2019ll have good years and bad years.<\/p>\n

When your rentals have a good year, you can invest more in stocks. When your stocks have a good year, you can invest more in rental properties (whether that means buying more properties, paying down mortgages, or making improvements to your existing properties).<\/p>\n

The trick is not to get greedy and spend more, when one or both of your portfolios has a good year. If you invest (or save) the extra earnings, you\u2019ll be prepared when the next big hurdle comes your way.<\/p>\n

If you go on a shopping spree, you\u2019ll be in trouble.<\/p>\n

Oh, and if you decide that buying and managing rental properties is more hassle than you can handle, there are other ways to invest in real estate. The obvious one is REITs, but you can also lend money on crowdfunding or peer-to-peer websites. Or you can invest in private notes.<\/p>\n

Or you can buy into cash flow sharing services, a relatively new entry in the real estate investing arena.<\/p>\n

While none of these give you the degree of control over your returns that managing your rental properties does, all of them are viable investing options. And they help balance your portfolio against losses in one area.<\/p>\n

Retirement & Financial Independence Don\u2019t Mean You Should Stop Working<\/h2>\n

Who says you have to stop working entirely?<\/p>\n

Increasingly, older adults are \u201csemi-retiring,\u201d rather than stopping work cold-turkey like the 20th<\/sup> Century model of retirement.<\/p>\n

Semi-retiring means continuing to work in some capacity, usually for lower pay, but doing work that is more rewarding in other ways. It could mean working a job that\u2019s fun and laid-back (personally, I\u2019d like to work at a winery when I semi-retire).<\/p>\n

Or it could mean giving back in some way\u2014teaching others, working for non-profits, or mentoring.<\/p>\n

Some people shift their focus to their real estate investments in retirement!<\/p>\n

Regardless, adults who semi-retire have a distinct advantage: They keep earning money. It may not be as much as they earned at their original 9-5, but it certainly helps them rely less on their investments.<\/p>\n

One nice thing about continuing to work is that you still have at least one foot in the working world. If the stock market crashes in Year 1, it\u2019s a lot easier to ask your boss for more hours or drum up some more self-employed or consulting work than it is to find a job or build a self-employed business from scratch.<\/p>\n

Adults who semi-retire are partially buffered against sequence risk because they won\u2019t be forced to sell much (if any) of their stock portfolio, just to pay their monthly bills.<\/p>\n

And for landlords, continuing to earn money by working helps keep them liquid in case an unexpected repair bill comes along.<\/p>\n

Oh, and one other advantage to semi-retirement? It can help you delay taking Social Security, so that you receive the maximum monthly payment.<\/p>\n

It\u2019s All About Diversity<\/h2>\n

Consider all the defenses to sequence risk we\u2019ve reviewed in this article:<\/p>\n