Getting Real with Retirement Planning: Understanding Sequence Risk

Clearly, there is a lot to think about when planning for retirement. While we have a degree of control over many of the choices involved, there’s one big wild card called sequence risk.

 

Sequence risk is the risk that you’ll encounter negative investment returns in early retirement. This is an important consideration, because the random sequence – or order – in which you earn your returns early in retirement can have a significant impact on your lasting wealth. Simply put, a retirement portfolio that happens to experience positive returns early in retirement will outlast an identical portfolio that must endure negative returns early in retirement … even if their long-term rates of return end up the same.

 

Since nobody can predict which return sequence they’ll experience early in their retirement, every family should prepare for a range of possibilities in their realistic retirement planning.

 

The Significance of Sequence Risk

It’s no secret that global stock markets are volatile. While long-term average annual returns may be in the range of 7%, markets rarely deliver this exact average any given year. Soaring one year, plummeting the next; we never know for sure how far above or below average each year will be.

 

During your career, you’re mostly spending earned income, while adding to your retirement reserves as aggressively as your plans call for. As long as you stay the course – benefiting from the upswings and enduring the downturns – tolerating market volatility is just part of the plan.

 

In fact, when you’re still accumulating wealth, market downturns give you the opportunity to buy more shares than you otherwise could when prices are higher. When the market recovers, you then have more shares to recover with, which ultimately strengthens your portfolio.

 

But then, you stop working, and start spending your reserves. This has an opposite effect. Now, when stock markets decline, you may need to sell shares at low prices, which means you’ll have to sell more of them to withdraw the same amount of cash. Even though the market is expected to eventually recover and continue upward, your portfolio will have fewer shares with which to participate in the recovery. This hurts your portfolio’s staying power. It won’t be able to bounce back as readily as when you were adding shares to it, or at least not taking them away.

 

Sequence Risk Illustrated

Consider two hypothetical retirees, Joan and Jane:

  • Both retire at age 65 with identical $1 million dollar stock portfolios.
  • Both start withdrawing $50,000 annually at the start of each year (not adjusted for inflation).
  • Both earn the same 7% average annual returns over their 25 years in retirement.

 

With so much in common, you might assume their portfolios would perform similarly. But what if Joan happens to enter into retirement during a horrible market? Let’s imagine her portfolio returns –30% and –20% in her first two years, while Jane earns 7% both years, and (implausibly) every year thereafter.

 

Markets recover nicely for Joan after two years so, again, she ultimately earns the same average 7% annual return as Jane. But sequence risk takes a heavy toll on Joan’s remaining shares. She ends up with only about $150,000, while Jane’s portfolio grows nicely to around $2 million.

 

Retirement Planning Asheville

For illustrative purposes only.

 

If we take the same two portfolios and same two sequences of returns – but eliminate the $50,000 annual withdrawals –Joan and Jane would both end up with about $5.4 million after 25 years. This illustrates why sequence of returns is usually not nearly as significant when you’re still accumulating wealth, but can matter quite a bit in the early years of depleting your portfolio.

 

retirement planning Asheville

For illustrative purposes only.

 

Managing the Sequence Risk Wild Card

Sequence risk should NOT change your overall approach to investing. As 2020 has clearly shown us, you never know what’s going to happen next. Crashes usually occur without warning, while some of the strongest rebounds arrive amidst the darkest days.

 

So, whether you’re 20, 40, 60, or 102, we still recommend building and maintaining a low-cost, globally diversified portfolio that reflects your personal goals and risk tolerances. We still advise against trying to pick individual stocks or react to current market conditions. We still suggest you only change your portfolio’s asset allocations if your personal goals have changed – never in raw reaction to changeable market moods.

 

What can you do to mitigate sequence risk if it happens to you?

 

Keep working. If you are willing and able, you might postpone retirement, or even return to the workforce. Even part-time employment can help offset an ill-timed sequence of negative market returns. If your circumstances allow, you may be able to not only avoid spending retirement reserves during down markets, but even add more in (buying at bargain prices).

 

Spend less. Were you planning for higher investment returns than reality has delivered? Since your portfolio is most vulnerable to negative sequence risks early in retirement, you may want to initially spend less than planned, to give your portfolio the fuel it needs to replenish itself.

 

Tap other assets. When you retire, you typically have several sources of income to draw from. You may have traditional investment accounts, retirement accounts, Social Security, or pension plans. Your investments are usually divided between stocks and bonds. You may have equity in your home. You may have, or be in a position to create an annuity. You may have cash reserves. If you encounter stock market sequence risk early in retirement, you might be able to tap a combination of your non-stock assets for initial spending needs. This can mitigate the hit your portfolio will otherwise have to take if you must liquidate shares of stock.

 

Consult with a financial advisor. Sequence risk is usually not the only consideration at play in retirement planning. There are taxes to consider. Estate plans to bear in mind. Carefully structured investment portfolios to maintain. Logistics to learn. All this speaks to the value an experienced advisor can add before, during, and after this pivotal time in your financial journey.

 

At Woodstone Financial we help our clients prepare for and mitigate sequence risk within the greater context of their goals for funding, managing, spending, and bequeathing their lifetime wealth. Please be in touch today if we can help you with the same.

 

 

 

 

Woodstone Financial, LLC is a fee-only financial advisor, specializing in retirement planning, comprehensive financial planning, and investment management firm located in Asheville, North Carolina.   Contact us to learn more about our services.

Lump-Sum Investing vs. Dollar-Cost Averaging

Some investors favor a dollar-cost averaging (DCA) approach to deploying their
investment capital. Unlike lump-sum investing, in which the full amount of available
capital is invested up front, DCA spreads out investment contributions using installments
over time. The appeal of DCA is the perception that it helps investors “diversify” the cost
of entry into the market, buying shares at prices that fall somewhere between the highs
and lows of a fuctuating market. So what are the implications of DCA for investors
aiming to generate long-term wealth?

 

ENTRY LEVEL

Let’s take the hypothetical example of an investor with $12,000 in cash earmarked for
investment in stocks. Instead of buying $12,000 in stocks today, an investor going the
DCA route buys $1,000 worth of stocks each month for the next 12 months. If the market
increases in value each month during this period, the DCA investor will pay a higher price
on average than if investing all up front. If the market decreases steadily over the next 12
months, the opposite will be true.

While investors may focus on the prices paid for these installments, it’s important to
remember that, unlike with the lump-sum approach, a meaningful portion of the
investor’s capital is remaining in cash rather than gaining exposure to the stock market.
During the process of capital deployment in this hypothetical example, half of the
investable assets on average are forfeiting the higher expected returns of the stock
market. For investors with the goal of accumulating wealth, this is potentially a big
opportunity cost.

Despite the drawbacks of dollar-cost averaging, some may be hesitant to plunk down all
their investable money at once. If markets have recently hit all-time highs, investors may
wonder whether they have already missed the best returns and so ought to wait for a
pullback before getting into the market. Conversely, if stocks have just fallen and news
reports suggest more declines could be on the way, some investors might take that as a
signal waiting to buy is the wiser course. Driving the similar reactions to these very
different scenarios is one fear: what if I make an investment today and the price goes
down tomorrow?

 

Financial Advisor Asheville Woodstone

 

Exhibit 1 puts those fears in a broader context. It shows the average annualized
compound returns of the S&P 500 from 1926–2019. After the index has hit all-time highs,
the subsequent one-, three-, and fve-year returns are positive, on average. After the S&P
500 has fallen more than 10%, the subsequent one-, three-, and fve-year returns are also
positive, on average. Both data sets show returns that outperform those of one-month
Treasury bills. Overall, the data do not support that recent market performance should
infuence the timing of investing in stocks.

 

DIFFERENT STROKES

Both theory and data suggest that lump-sum investing is the more effcient approach to
building wealth over time. But dollar-cost averaging may be a reasonable strategy for
investors who might otherwise decide to stay out of the market altogether due to fears
of a large downturn after investing a lump sum.
The stock market has offered a high average return historically, and it can be an
important ally in helping investors reach their goals. Getting capital into stocks, whether
gradually or all at once, puts the holder in position to reap the potential benefts. A
trusted fnancial advisor can help investors decide which approach—lump-sum investing
or dollar-cost averaging—is better for them. What’s clear is that markets have rewarded
investors over time. Whichever method one pursues, the goal is the same: developing a
plan and sticking with it.

 

 

 

 

 

 

 

 

The information in this document is provided in good faith without any warranty and is intended for the recipient’s background information
only. It does not constitute investment advice, recommendation, or an offer of any services or products for sale and is not intended to provide
a suffcient basis on which to make an investment decision. It is the responsibility of any persons wishing to make a purchase to inform
themselves of and observe all applicable laws and regulations. Unauthorized copying, reproducing, duplicating, or transmitting of this
document are strictly prohibited. Dimensional accepts no responsibility for loss arising from the use of the information contained herein.
“Dimensional” refers to the Dimensional separate but affliated entities generally, rather than to one particular entity. These entities are
Dimensional Fund Advisors LP, Dimensional Fund Advisors Ltd., Dimensional Ireland Limited, DFA Australia Limited, Dimensional Fund
Advisors Canada ULC, Dimensional Fund Advisors Pte. Ltd, Dimensional Japan Ltd., and Dimensional Hong Kong Limited. Dimensional Hong
Kong Limited is licensed by the Securities and Futures Commission to conduct Type 1 (dealing in securities) regulated activities only and
does not provide asset management services.

UNITED STATES: Dimensional Fund Advisors LP is an investment advisor registered with the Securities and Exchange Commission

 

 

Woodstone Financial, LLC is a fee-only financial advisor, specializing in retirement planning, comprehensive financial planning, and investment management firm located in Asheville, North Carolina.   Contact us to learn more about our services.

What Is Fiduciary Advice, and Why Does It Matter (Now More Than Ever)?

How do you know when an investment recommendation is worth heeding?

 

Red tape and legal jargon aside, it’s about finding an advisor who exemplifies a few simple ideals:

 

“There’s no confusion in the minds of investors as to what they want. They’re very clear. They want somebody they trust who makes recommendations that put their interest first and don’t allow the advisor to profit financially at their expense.”

Phyllis Borzi, Dept. of Labor EBSA head, 2009–2017

 

That makes sense, doesn’t it? There’s even a term the investment world has been using since at least the 1940s to describe this highest standard. It’s called fiduciary advice.

 

Why Fiduciary Advice (Still) Matters

Fiduciary advice makes sense to us too. Investors deserve nothing less than the fairest possible shake from anyone entrusted with advising them about their personal wealth. For decades, the fiduciary standard has shaped this highest level of care for those of us committed to delivering it.

 

Having a fiduciary duty to our clients puts us on similar footing with other professional consultants, such as physicians or attorneys. You hire us partly because we have dedicated our career to understanding every facet of your wealth. But you also hire us to always use our knowledge to advise you according to your highest financial interests – even ahead of our own.

 

However, to our frustration, it has probably become harder instead of easier for you to know when you are receiving this level of care … and just as significantly, when you are not. As Borzi adds, “everybody claims to be a trusted advisor when some are really only salespeople.”

 

Unfortunately, the fiduciary standard has been under attack lately. A recent Securities and Exchange Commission (SEC) overhaul has downplayed rather than strengthened its significance by overlaying it with a new industry standard, paradoxically called “Regulation Best Interest.”

 

Regulation Best Interest: One Size Fits None?

You may not have marked the day, but June 30th, 2020 was a big one for financial practitioners across the country. It was the day the SEC’s Regulation Best Interest (Reg BI) took effect.

 

Reg BI does not require you as an investor to do anything. It’s aimed at those of us offering you investment advice or recommendations. Here is an SEC excerpt:

 

“[Reg BI is] designed to enhance the quality and transparency of retail investors’ relationships with investment advisers and broker-dealers, bringing the legal requirements and mandated disclosures in line with reasonable investor expectations, while preserving access (in terms of choice and cost) to a variety of investment services and products.”

 

At face value, this seems reasonable, if vague. Here’s more from the SEC (emphasis ours):

 

“Individually and collectively, these actions are designed to enhance and clarify the standards of conduct applicable to broker-dealers and investment advisers, help retail investors better understand and compare the services offered and make an informed choice of the relationship best suited to their needs and circumstances, and foster greater consistency in the level of protections provided by each regime, particularly at the point in time that a recommendation is made.”

 

Still not crystal clear? In English, the intent is to ensure you (the “retail investor”) have enough information to decide whether a professional investment recommendation is best suited to your needs, essentially no matter who is offering it.

 

That still seems logical enough. But let’s take a closer look at how investment advice “best suited” for you in theory may translate in practice.

 

“Apple and Orange” Advisory Differences

In our mind, new regulations should either eliminate, or at least make it easier for investors like you to recognize two very different practices that still exist side by side in the financial industry:

 

  • “Full-time” fiduciary advisors offer a fiduciary level of care throughout their relationship with you. |
  • “Best interest” recommendations can be one-off pieces of advice you may receive during point-in-time transactions.

 

Despite its promising name, Reg BI may muddy what clarity had existed between these higher and lesser standards of care. By attempting to apply the same broad rules to both, Reg BI has the potential to discount the still-stark differences between them:

 

A Reg BI Checklist for Fiduciary vs. Broker-Dealer Investment Recommendations

  Ideal Full-Time Fiduciary Advice Typical Broker-Dealer Investment Advice
Relationship Your advisor’s sole, continuous duty is to advance your highest financial interests (even ahead of their own). A broker, banker or insurance rep offers other core services, along with point-of-sale investment recommendations.
Primary Role Your advisor deeply understands and accounts for the details of your total wealth interests, and advises you accordingly, always in a fiduciary capacity. A broker’s primary role is to transact trades; a banker custodies accounts; an insurance rep sells insurance. Incidental investment advice is secondary to these roles. Not all transactions are subject to fiduciary duty.
Employment Status As a fully independent Registered Investment Advisor (RIA) firm, your advisor’s only “boss” should be investor clients like you. Employed by a bank, brokerage house or insurance agent, a broker-dealer’s, banker’s, or agent’s “boss” is their employer.
Compensation Your advisor’s compensation should preferably be fee-only, so their only financial incentives come from investor clients like you. Commissioned or fee-based intermediaries earn part or all of their keep from their employer or through other (often opaque) sales incentives.
Investment Plan First, it’s essential to have a plan. It should be grounded in evidence over emotion, structured to manage all your investments in unity, and tailored to patiently capture expected returns according to your personal goals and risk tolerance. Investment recommendations are more typically offered as a point-of-sale, add-on service. They are unlikely to be guided by your big-picture plans; coordinated with the rest of your assets; or personalized to advance your total wealth interests.
Conflicts of Interest Ideally, your advisor has minimized any conflicts of interest by embracing all of the above best practices – not only because it’s required, but because it’s the right thing to do. New regulations aimed at minimizing and disclosing conflicts of interest may have been tacked onto, rather than integrated into the company’s core role and mission.

Our Take on Reg BI: Less Isn’t Always More

How could one set of regulatory rules apply equally to both lesser and higher standards of care?

 

In theory: Both groups should minimize their conflicts of interest, and disclose any inherent conflicts they cannot eliminate.

 

In reality: When is the last time you read a financial disclosure, and understood what it meant or asked probing questions until you did? For most of us, it’s been a while. As such, legal disclosures alone may fail to protect investors from falling for sales pitches in disguise.

 

In practicality, this means:

 

  • Continued double standards: Suffice it to say, Reg BI leaves some large legal loopholes to be leveraged by those who wish to continue offering incidental investment advice.
  • Business as usual: “Best interest” recommendations may still end up tainted by unnecessary conflicts of interest (such as compensation models that don’t actually align with investors’ best interests) and/or an incomplete understanding of your greater financial goals.
  • More due diligence: You, the investor, must still sort out which side of the table an investment recommendation is coming from. Worse, the well-established terminology that used to help you distinguish fully fiduciary from merely suitable advice has been subsumed under the fuzzier, untested language of Reg BI.

 

What Comes Next?

To say the least, we are underwhelmed by Reg BI – and we are not alone.

 

Jane Bryant Quinn, a veteran financial journalist, described the new landscape as follows:

 

“[Reg BI] creates fake fiduciaries. It’s a disaster for investors because now a salesperson can basically say, ‘I have your best interest at heart — I put your interest ahead of mine.’ They’re allowed to use exactly the same language that fiduciaries use but without actually being fiduciaries.”

 

Here is additional commentary from Borzi:

 

“Ironically, the final [Reg BI] product that emerged from the SEC not only did not address this endemic problem of conflicted compensation, but also exacerbated investor confusion by allowing brokers to market themselves as working in their clients’ best interest without actually holding them to a clear, fiduciary best-interest standard or ending the harmful incentives that conflict with that standard.”

 

Here is one more take from “Nerd’s Eye View” financial thought leader Michael Kitces:

 

“[I]n issuing the new Regulation Best Interest rules, the SEC declined to equalize the standard of care for broker-dealer-delivered versus RIA-delivered advice as mandated by Dodd-Frank, and instead expanded the broker-dealer exemption that would allow broker-dealers to even more easily provide comprehensive financial planning advice without being subject to a fiduciary standard for that advice … which creates, literally, a double-standard for the delivery of financial planning advice.”

 

Fortunately, this tale of fiduciary peril is not yet over. We, Kitces, Borzi, and many others like us continue to press for legal, political, and industry reforms to cut through the confusion.

 

We hope to update this important piece over time with improved news. Until then, we encourage you to use the table above as a handy checklist for determining when an investment recommendation is most likely to truly be in your highest financial interest … and when it is not.

 

What additional questions can we address for you at this time?  Please let us know.

 

 

 

 

Woodstone Financial, LLC is a fee-only financial advisor, specializing in retirement planning, comprehensive financial planning, and investment management firm located in Asheville, North Carolina.   Contact us to learn more about our services.

Market Returns and Election Years

It’s almost Election Day in the US once again. While the outcomes of the elections are uncertain, one thing we can count on is that plenty of opinions and prognostications will be floated in the months to come. In financial circles, this will almost assuredly include any potential for perceived impact on markets. But should long-term investors focus on elections?

 

Market Returns and Election Years Infographic

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Markets Work

We would caution investors against making short-term changes to a long-term plan to try to profit or avoid losses from changes in the political winds. For context, it is helpful to think of markets as a powerful information-processing machine. The combined impact of millions of investors placing billions of dollars’ worth of trades each day results in market prices that incorporate the aggregate expectations of those investors. This makes outguessing market prices consistently very difficult.1 While surprises can and do happen in elections, the surprises don’t always lead to clear-cut outcomes for investors.

The 2016 presidential election serves as a recent example of this. There were a variety of opinions about how the election would impact markets, but many articles at the time posited that stocks would fall if Trump were elected.2 The day following President Trump’s win, however, the S&P 500 Index closed 1.1% higher. So even if an investor would have correctly predicted the election outcome (which was not apparent in pre-election polling), there is no guarantee that they would have predicted the correct directional move, especially given the narrative at the time.

But what about congressional elections? For the upcoming midterms, market strategists and news outlets are still likely to offer opinions on who will win and what impact it will have on markets. However, data for the stock market going back to 1926 shows that returns in months when midterm elections took place did not tend to be that different from returns in any other month.

Exhibit 1 shows the frequency of monthly returns (expressed in 1% increments) for the S&P 500 Index from January 1926–December 2019 Each horizontal dash represents one month, and each vertical bar shows the cumulative number of months for which returns were within a given 1% range (e.g., the tallest bar shows all months where returns were between 1% and 2%). The blue and red horizontal lines represent months during which a presidential election was held, with red meaning Republicans won and blue representing the same for Democrats.

EXHIBIT 1

Presidential Elections and S&P 500 Index Returns, Histogram of Monthly Returns

In It for the Long Haul

While it can be easy to get distracted by month-to-month or even one-year returns, what really matters for long-term investors is how their wealth grows over longer periods of time. Exhibit 2 shows the hypothetical growth of wealth for an investor who put $1 in the S&P 500 Index in January 1926. Again, the chart lays out party control of presidency over time. And again, both parties have periods of significant growth and significant declines during their time of majority rule. However, there does not appear to be a pattern of stronger returns when any specific party is in control, or when there is mixed control for that matter. Markets have historically continued to provide returns over the long run irrespective of (and perhaps for those who are tired of hearing political ads, even in spite of) which party is in power at any given time.

EXHIBIT 2

Hypothetical Growth of $1 Invested in the S&P 500 Index and Presidential terms

Presidential terms and markets

Equity markets can help investors grow their assets, and we believe investing is a long-term endeavor. Trying to make investment decisions based on the outcome of elections is unlikely to result in reliable excess returns for investors. At best, any positive outcome based on such a strategy will likely be the result of random luck. At worst, it can lead to costly mistakes. Accordingly, there is a strong case for investors to rely on patience and portfolio structure, rather than trying to outguess the market, to pursue investment returns.

 

 

 

 

 

 

Market Returns During Election Years

These unbranded slides take a historical look at how major US, international developed, and emerging markets indices have performed during or after a US presidential election.

FOOTNOTES

  1. 1This is known as the efficient market theory, which postulates that market prices reflect the knowledge and expectations of all investors and that any new development is instantaneously priced into a security.

  2. 2Examples include: “A Trump win would sink stocks. What about Clinton?” CNN Money, 10/4/16, “What do financial markets think of the 2016 election?” Brookings Institution, 10/21/16, “What Happens to the Markets if Donald Trump Wins?” New York Times, 10/31/16.

DISCLOSURES

In USD. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. Diversification does not eliminate the risk of market loss.

There is no guarantee investment strategies will be successful. Investing involves risks, including possible loss of principal. Investors should talk to their financial advisor prior to making any investment decision. There is always the risk that an investor may lose money. A long-term investment approach cannot guarantee a profit.

All expressions of opinion are subject to change. This information is intended for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services.

Dimensional Fund Advisors LP is an investment advisor registered with the Securities and Exchange Commission.

Woodstone Financial, LLC is a fee-only financial advisor, specializing in retirement planning, comprehensive financial planning, and investment management firm located in Asheville, North Carolina.   Contact us to learn more about our services.