Market downturns in first few years of retirement can thwart best-laid plans

Portfolio returns in the early years of retirement could have a large bearing on the success or failure of a retirement income strategy; a few years of early market appreciation means a high likelihood for a healthy retirement, while a flat or declining market in the early years could throw a wrench into the calculation. It is called sequence-of-return risk, and it poses a serious conundrum for advisers putting together a retirement-income plan for clients. "The sequences have an incredible effect on the outcomes, even for identical long-term returns," Michael Kitces, partner and director of research at Pinnacle Advisory Group, said Tuesday at InvestmentNews' annual Retirement Income Summit in Chicago. It's not purely about market crashes early in retirement — the speed with which markets recover is the more important factor, said Mr. Kitces, who's also co-founder of the XY Planning Network. And, "we are in the kind of an environment where this stuff matters," Mr. Kitces said. That's because there's an inverse relationship between price-to-earnings ratios and safe retirement withdrawal rates, Mr. Kitces said. Given fairly high valuations at the present time, there's a high likelihood the next 10- to 15-year returns will be well below average, he added. Mr. Kitces highlighted three strategies to deal with sequence-of-return risk: safe withdrawal rates, dynamic asset allocation and dynamic spending. DYNAMIC ASSET ALLOCATION​ Bucket strategies, an annuitization floor, rising equity glidepath, and valuation-based allocation are examples of dynamic asset allocation. A bucket strategy segments spending into different investment groups over certain time horizons. Short-term spending needs (those in the first three retirement years) are managed with cash; the subsequent seven years (years four through 10 of retirement) use fixed income (bonds, bond funds and annuities, for example); and the remainder uses equities. This way, clients don't touch equity holdings for a decade, providing a long time horizon to allow for portfolio recovery in the event of an early market crash or flat markets. Roughly 15% of the portfolio would be in cash, 35% in fixed income and 50% in equities. Advisers can segment a portfolio into "essential" and "discretionary" expenses, attaching guaranteed income streams like immediate annuities and Social Security to essential living expenses and the remainder of the portfolio to the more flexible expenses, Mr. Kitces said. So, clients can trim their flexible spending in the event of an unfavorable market sequence, he said. This annuitization floor can have a positive unintended consequence for clients: a rising equity glidepath. Basically, because a client's tendency is to spend the money from annuities and Social Security first, prior to tapping portfolio assets, it allows for greater portfolio growth and boosts equity allocations over time. So, long-term annuitization is a "super sneaky way" to get clients to own more in stocks, and buffer against a market downturn, Mr. Kitces said. Valuation-based allocations involve making tilts in the portfolio based on market valuations — any time valuations shift outside two standard deviations, and advisers can adjust the portfolio accordingly. "When you make these kinds of valuation tilts, you end up with a moderate lift in safe withdrawal rates," Mr. Kitces said. It's an infrequent adjustment, though — an adviser would only realistically need to do this a few times over a decade, Mr. Kitces said. SAFE WITHRAWAL RATES The 4% rule is an example of a safe-withdrawal rate strategy, or one that looks at how quickly one can draw down a retirement portfolio and not run out of money. But the 4% withdrawal strategy is "grossly unnecessary" most of the time, Mr. Kitces said, because it is often too conservative. Looking at historical data, Mr. Kitces said using the 4% withdrawal rule is only necessary roughly 4% of the time; 96% of the time, clients would die without having touched their principal, and 50% of the time they would have left double the principal. Advisers can start with a base withdrawal rate or 4%-4.5%, and make adjustments based on fees and alpha, taxes, time horizon, diversification, risk tolerance and the valuation environment, for example, to determine the final safe withdrawal rate for a client, Mr. Kitces said. DYNAMIC SPENDING There are two categories of dynamic spending: spending ratchets and floor/ceiling guardrails. Ratcheted spending involves starting with a safe withdrawal base, but re-evaluating that every three years and ratcheting up the rate of spending in good markets. Starting conservative provides a buffer in the event of poor return sequences. Dynamic spending is similar to "bumper lanes in a bowling alley," Mr. Kitces said, setting thresholds within a certain high and low. For example, if an adviser sets client spending at 5%, and that rate increases to 6% due to portfolio trouble (the client draws the same amount from a smaller asset base), the client would take a spending cut; if the market does well and the rate declines to 4%, spending can be increased. However, levels shouldn't necessarily be absolute throughout retirement — advisers will likely adjust according to factors such as longevity time horizon, for example, Mr. Kitces said. ​