Sequence Risk: How to Ensure Your Nest Egg Doesn’t Go Belly Up Before You Do

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“What happens if the stock market crashes right after I retire?”

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

Not surprisingly, one of the issues that’s come up is “sequence risk” or “sequence of return risk.” It’s a big concern for new retirees, or at least it should be (especially in today’s aging bull market).

Fortunately, new retirees have plenty of options!

Here’s what you need to know about sequence risk, whether you’re 30 years or 30 days away from retiring.

What Is Sequence of Return Risk?

Sequence risk is the risk that the market (usually the stock market, but technically any market you’re invested in) will crash within the first few years of your retirement.

What’s the big deal? Why is the timing so important?

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’ll have to sell many more shares to achieve the same income.

Let’s say you’re selling $50,000 worth of stocks each year in your retirement. If the market crashes by 30%, you’ll need to sell 30% more stocks than you did before the crash, to pull that same $50,000 out for your expenses.

So, you’re burning through your portfolio 30% faster. And not just during the crash, either—you’ll be burning through your stocks faster for years, until the market eventually recovers to the pre-crash level.

That could be over a decade. The Nasdaq took 15 years to recover after the crash of the early 2000s!

The second reason is that the crash is all downside for you since you’re only selling, not buying. You won’t benefit from the crash as a “discount sale on stocks” because you’re not buying when stocks are dirt cheap.

Two Portfolios to Illustrate Sequence Risk

Visual learner? Or just like math?

Cool. (See, kids? Math can be cool!)

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.

In Scenario 2, the first 10 years’ returns are reversed, so that nasty 29% stock market crash hits Cindy on her 10^th year, rather than her first.

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

After 20 years, Cindy is broke in Scenario 1, but is still going strong in Scenario 2:

If you want to look at the data I used, here’s a table:

Year	Scenario 1 Return	Scenario 1 Balance	Scenario 2 Return	Scenario 2 Balance
0		$100,000		$100,000
1	-29%	$66,740	28%	$120,320
2	8%	$65,599	9%	$124,609
3	-16%	$50,063	12%	$132,842
4	14%	$50,232	9%	$138,258
5	8%	$47,771	10%	$145,483
6	10%	$45,948	8%	$150,642
7	9%	$43,543	14%	$164,892
8	12%	$42,048	-16%	$133,469
9	9%	$39,293	8%	$137,667
10	28%	$42,615	-29%	$93,483
11	12%	$41,008	12%	$97,981
12	10%	$38,509	10%	$101,180
13	9%	$35,435	9%	$103,746
14	-5%	$27,963	-5%	$92,858
15	-11%	$19,547	-11%	$77,304
16	23%	$16,663	23%	$87,704
17	13%	$12,049	13%	$92,325
18	18%	$7,138	18%	$101,864
19	-16%	$956	-16%	$80,526
20	12%	-$5,649	12%	$83,469
Avg. Return:	5.30%		5.30%

 

Before you say, “Cindy should have followed the 4% Rule” or “5.3% is on the low side historically for stock market returns,” or “How does she live on $6,000/year?”, know that I’m illustrating a point here, gosh darn it!

Sequence risk—the order in which you earn your returns—matters.

The Typical Answers from Financial Advisors

If we had a standard-issue financial advisor in the room, the first thing she would say is, “This is why we talk about asset allocation with retirees. Cindy should have had more of her portfolio in bonds.”

About now is when they cart out the “Rule of 100,” where they say you subtract your age from 100, and that’s what percentage of your portfolio should be in stocks.

Except I don’t like the Rule of 100. The go-to investment that financial advisors say retirees should focus on is bonds, but bonds’ returns have just plain sucked for, like, 20 years now. (How’s that for scientific?)

Alright, alright, here’s a chart on long-term U.S. Treasury yields for you:

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 “I thought the whole point of switching to bonds was to minimize my risk?”

One answer that your financial advisor might put forth is to make sure you’re taking advantage of Roth IRAs. The proceeds are tax-free, so you won’t have to pull out extra money for income taxes. They also don’t force you to start withdrawing funds when you reach 70½ (like regular IRAs do), so you can give them a little longer to grow and avoid selling in a down market.

Two Other Ideas from Financial Advisors

One financial advisor gave my mother a different idea. He proposed that she and my stepfather pull several years’ worth of expenses out before retiring and set them aside in cash.

That way, if the stock market crashes within the first few years of their retirement, they don’t have to sell during the crash.

They’ll take a hit on inflation, of course. They’ll also incur opportunity costs—they’ll lose the potential returns they would have earned if that money had been out working for them.

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.

Another idea is that retirees could use trailing stop orders to limit their losses in the event of a crash. If you’re not a nerd about this stuff, a trailing stop order 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’s value upward, and use its highest value as the reference point.

For example, you buy a mutual fund and set a trailing stop order of 5%. The fund rises and rises and rises—then 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.

Where Do Rental Properties Fit In?

Get to the real estate already!

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

Let’s 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.

But second, Cindy has some control over her cash flow. Landlords’ cash flow is about taking long-term averages of expenses, not what happens in a “typical” month. For instance, a $5,000 new roof is averaged into the monthly cash flow as part of CapEx.

Consider this, though—Cindy 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?

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

So, she patches the roof, and buys herself another 18 months.

Or imagine she has renters who are thinking about moving. Cindy knows the turnover will leave her with at least one or two months’ 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.

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.

These maneuvers won’t change the long-term averages of her costs—vacancies, 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.

Real Estate as a Counterweight to Stocks

Some years, stocks will perform well for you. Likewise with your rental properties; with all your investments, you’ll have good years and bad years.

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).

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’ll be prepared when the next big hurdle comes your way.

If you go on a shopping spree, you’ll be in trouble.

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.

Or you can buy into cash flow sharing services, a relatively new entry in the real estate investing arena.

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.

Retirement & Financial Independence Don’t Mean You Should Stop Working

Who says you have to stop working entirely?

Increasingly, older adults are “semi-retiring,” rather than stopping work cold-turkey like the 20^th Century model of retirement.

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’s fun and laid-back (personally, I’d like to work at a winery when I semi-retire).

Or it could mean giving back in some way—teaching others, working for non-profits, or mentoring.

Some people shift their focus to their real estate investments in retirement!

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.

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’s 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.

Adults who semi-retire are partially buffered against sequence risk because they won’t be forced to sell much (if any) of their stock portfolio, just to pay their monthly bills.

And for landlords, continuing to earn money by working helps keep them liquid in case an unexpected repair bill comes along.

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

It’s All About Diversity

Consider all the defenses to sequence risk we’ve reviewed in this article:

• Bonds
• Liquidating a few years’ income before retirement
• Trailing stop orders
• Rental properties
• Alternative options for investing in real estate
• Semi-retirement

What do they all have in common?

Well, OK, trailing stop orders are an outlier, but the other tactics are all about diversifying your assets. Even more importantly, they’re about diversifying your passive income.

I love equities. I plan to keep investing in them, alongside real estate. But the closer you get to retirement, the more attention you have to pay to sequence risk, to make sure your nest egg doesn’t go belly up before you do.

Where are you in your retirement planning? What are your plans to manage sequence risk?

Let’s get nerdy!

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.