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What is Sequence Risk?

A common assumption when planning for retirement is that your portfolio will grow at an average rate each year. This helps simplify projections when determining if your nest egg is sufficient enough to last through your retirement.

However, in the real world, future investment returns are rather unpredictable from year to year. This means a string of poor investment returns is not uncommon and can potentially cause your returns to be lower than expected. This is known as sequence risk.

The Potential Impact Sequence Risk Can Have on Your Retirement

If a series of negative returns occurs during the period leading up to or immediately after your retirement, there could be a major impact on your retirement nest egg. This is because sequence risk amplifies investment volatility since you are selling shares at a depressed value to fund your retirement expenses.

As a result, there could potentially be a permanent impairment in the amount of retirement income you could generate from your portfolio if there was a dramatic market decline early in your retirement.   

How to Potentially Mitigate Sequence Risk

Unfortunately, there is little you can do to control the economy or stock market conditions surrounding your retirement. However, you are able to take steps to attempt to insulate your portfolio from the volatility of the market.

This means you could carve out portions of your nest egg and place it in investments that attempt to mitigate risk to fund your upcoming years of retirement spending. This way you do not have to sell other investments that may have decreased in value but instead are using funds that were already set aside for that purpose.

In addition, it could make sense to reduce your discretionary spending during a period of poor returns. This could include, postponing a trip, delaying major purchases, or cutting your portfolio withdraws by a certain percentage.

During this time, you could also look to tap other sources of liquidity to allow your investment portfolio to recover.

Conclusion

With a retirement that could last 30+ years, it is important to consider the impact that a sequence of negative investment returns early on can have on the longevity of your nest egg. Awareness of this risk allows you to develop a strategy to attempt to mitigate this risk during the years surrounding your retirement.

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Feel free to email us at info@westernreservecm.com with any questions you have. If you would like to schedule time with us to discuss your specific situation click here.

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Understanding Longevity Risk

One of the key assumptions in a financial plan is how long you expect retirement to last.  However, the longer you expect to live, the greater the possibility you could run out of money in retirement.

This is what’s known as longevity risk. With longevity risk, the concern is not about dying early, but rather living longer than anticipated. For married couples, this means looking at the likelihood that one of the two of you will live much longer than expected.

Estimating Your Longevity with Software

A useful tool when estimating your, and your spouse’s, longevity is the Actuaries Longevity Illustrator (ALI) which was developed by the American Academy of Actuaries and the Society of Actuaries.¹  

Their projections are based on mortality tables used by the Social Security Administration in the annual Trustees’ Report and separate rates are used for males and females. They also assume the trend of improving longevity will continue when making their projections.

To account for individual differences, they make additional adjustments based on four other factors (age, gender, smoking, and health.) They have found that these factors account for significant individual variations in longevity.  

Their models suggest a retirement period lasting 30 years (to age 95) would be appropriate for the average, non-smoking, 65-year-old male/female couple retiring today.

Longevity’s Potential Impact on Your Retirement Plans

Once you have a grasp on what your potential retirement horizon may be, you might begin to view some financial decisions differently. Some of these decisions include:

When you decide to retire

Knowing that your retirement may last 30+ years could cause you to rethink when you retire. This could be due to not having enough saved to cover your future expenses. Or it could be that want to gradually reduce how much you work over several years before finally retiring.

When you claim Social Security

Social Security is a source of retirement income that can help protect you from longevity risk. This is because your benefits are adjusted annually for inflation, and continue for your lifetime.

Additionally, if you’re married, your spouse could receive survivor benefit payments once you pass. With this in mind, it’s important to consider when you claim your Social Security benefits.

It may make sense to not receive your benefits as soon as possible since you will receive a larger benefit by delaying. If you can wait until age 70, you will receive what is considered the maximum benefit.

How you invest in retirement

With a retirement that could last decades, it’s important to invest your retirement assets with a goal of maintaining your standard of living throughout retirement.

This means you must have a mix of assets that allows you to fund your current needs while providing you the potential for long-term growth to meet your future spending needs.

Conclusion

Although longevity risk can pose a serious threat to your retirement plans, its impact can be mitigated with prudent planning and using reasonable assumptions for how long you and your spouse may live.

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Endnotes

1. See American Academy of Actuaries and Society of Actuaries, Actuaries Longevity Illustrator, http://www.longevityillustrator.org/ (accessed September 21, 2021).

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Feel free to email us at info@westernreservecm.com with any questions you have. If you would like to schedule time with us to discuss your specific situation click here.

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What Causes Company-Specific Risk

Oftentimes, those who have accumulated significant wealth did so through the concentrated holdings of stock/option compensation from an employer, business ownership, a successful long-term investment, or inheritance.

This can mean their ability to fund their retirement can be contingent on the continued prosperity of a specific asset. Although this concentrated investment strategy allowed you to generate your current nest egg, it may not make sense from a risk/reward perspective to continue to hold these assets.

This is because holding a large percentage of your retirement portfolio in a single asset increases something known as “unsystematic” risk. Unsystematic or company-specific risk is an additional kind of risk you take on when investing in an undiversified asset.

To illustrate this point J.P. Morgan Asset Management published a report on how often a concentrated position would have underperformed the Russell 3000 Index from 1980 to 2020. They found about 2/3rds of the time, a concentrated holding in a single company would have underperformed a diversified holding in the Russell 3000 Index.

A potentially more alarming finding was approximately 40% of all Russell 3000 Index components lost at least 70% of their value and never recovered.

However, the potential permanent loss of value that comes from holding a single asset can be mitigated through diversification. Proper diversification can limit the risk you take to “just” the inherent risk that comes with investing in the market. 

Potential Barriers to Reducing Company-Specific Risk

In theory, diversifying a concentrated holding should be a relatively straightforward process. You would simply sell a portion, or all, of the asset and invest the proceeds based on your long-term investment strategy.

In the real world, the diversification process can be more complex due to the following factors:

Taxes

Many times, holdings in a single asset have large unrealized gains, as a result of years of compound growth. Selling this asset would create a large tax bill that many would find undesirable. As a result, many continue to defer the sale indefinitely due to their unwillingness to pay taxes.

Although, if the position happens to be in a tax-deferred or tax-free account, there will not be tax consequences on the sale of the position. The tax liability would not be a factor in this case.

The Endowment Effect

There is something known as the “endowment effect” where you value something more, simply because you own it. It could be the stock of a company you’ve worked at or your share of a business you started. Or this holding could have been inherited from a spouse, parent, or grandparent, and as a result, carries a strong emotional attachment. 

This attachment can tilt your investment decisions. You may continue to hold the asset even if it doesn’t fit in your investment strategy. 

Future Regret (FOMO)

Often you don’t want to sell an asset because you are afraid you will miss the opportunity of future gains. This is especially true with an investment you have seen have significant appreciation in value. You can become overconfident that this past success will continue into the future and will regret ever selling.

A Question to Ask Yourself When Thinking About Company-Specific Risk

With these barriers potentially clouding your judgment, we have found this question helpful when thinking about selling an asset.

“If you didn’t own this asset, but instead had the equivalent amount in cash, how much would you buy of it today?”

Let your answer dictate how you should proceed. If you would feel comfortable buying less than you currently own, or none at all, it may be time to create a diversification strategy.

Create a Diversification Strategy

Having a diversification strategy can allow you to incorporate the sale of this asset with the rest of your retirement plan. Depending on the size of the position, it may make sense to sell portions of the asset over a number of years. Doing this can allow you to spread your tax liability over time while still diversifying away from the position.

Also, the annual sales could be coordinated with your retirement cash flow plan. This could allow you to take advantage of other retirement income-boosting strategies such as delaying your Social Security benefit.

A final option for those who are charitably minded is to donate some, or all, of the assets to charity. By donating the financial asset held for more than 12 months, you can avoid paying capital gains taxes. In addition, your gift may be deductible for income tax purposes.  

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The company-specific risk that comes with concentrated holdings can be mitigated through diversification. However, the process of selling can have many nuances. Having a diversification strategy in place could be useful when making investment decisions that have tax and emotional implications.

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Feel free to email us at info@westernreservecm.com with any questions you have. If you would like to schedule time with us to discuss your specific situation click here.

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Breaking Down Important Retirement Milestones

As you approach retirement there are certain age-based milestones you should be aware of. Some of these milestones create potential planning opportunities to boost savings, maximize retirement income, or improve tax efficiency.

Others mark deadlines that could result in stiff penalties if overlooked. Below, I have listed each key retirement milestone by age along with a description.

Age 50

Once you reach age 50, you can begin taking advantage of something called catch-up contributions. This provision allows you to increase your annual contributions to qualified retirement accounts during what could be the high-earning part of your career.

For instance, in 2021, participants in 401(k), 403(b), and governmental 457(b) plans can contribute as much as $19,500 per year. However, those who are age 50 and older can contribute an additional $6,500.

Additionally, there are catch-up contributions for eligible traditional and Roth IRA account holders age 50 and older. You can save an additional $1,000 above the base $6,000 federal contribution limit in 2021.

Age 55

At age 55 you are able to withdrawal employer-sponsored retirement plan savings without incurring the 10% early withdrawal penalty if you leave your job or retire. Important: This only applies to assets in your current 401(k) or 403(b) and money in a former 401(k) or 403(b), or individual retirement account, is not covered. Also, if you were to roll over those assets after leaving your job, you would lose your eligibility for early penalty-free withdrawals. 

In addition, this is the age where you can make catch-up contributions to your HSA account. For those eligible, the annual catch-up contribution is $1,000 above the 2021 limits of $3,600 for self-coverage and $7,200 for family coverage. However, any employer contributions that are excludable from your income reduce your contribution limit.

Age 59.5

After age 59.5 withdrawals from qualified retirement accounts are not subject to the 10 percent early withdrawal penalty. This includes employer plans such as 401(k)s, 403(b)s, and 457s, Traditional IRAs, Roth IRAs*, Simple/SEP IRAs, and annuities. For Roth IRA distributions, they must meet the five-year holding requirement in addition to taking place after age 59.5.

Age 62

62 is the earliest age you can claim Social Security benefits. *  Depending on the year you were born, your monthly benefit will be permanently reduced by 25 to 30 percent of your full retirement age (FRA) amount.

Also, something called the retirement earnings test could reduce the social security benefits you receive prior to FRA if your employment income is above certain thresholds. *Important: Surviving spouses can claim survivor benefits as early as age 60.

Age 65

For those eligible, the initial enrollment period for Medicare starts three months before the month you turn 65 and ends three months after the month you turn 65. Failure to enroll during this window could result in gaps in coverage or potential late enrollment penalties.

Age 66-67

Depending on your year of birth, your Full Retirement (FRA) Age for Social Security is anywhere between 66 and 67. FRA is when you are entitled to receive 100 percent of your primary insurance amount (PIA.)

Age 70

This is the last age you can receive delayed retirement credits (DRCs) for your Social Security benefit. There is no advantage to waiting to file for benefits beyond age 70.

Depending on your year of birth, this could result in you receiving up to 124 to 132 percent of your full retirement age benefit.

Age 70.5

Traditional IRA owners may begin making qualified charitable distributions (QCD’s) at age 70.5. A QCD, allows you to donate directly to an eligible qualified 501(c)(3) charity. This distribution is then excluded from your taxable income. The annual QCD limit is $100,000 per individual.

Age 72

The year you reach age 72 you must begin taking required minimum distributions (RMDs) from your employer-sponsored retirement plans and traditional IRAs. Your annual RMD is based on your age, the value of your accounts on December 31 of the previous year, and your life expectancy factor.

If you do not take your required minimum distribution by the applicable deadline, the amount not withdrawn is subject to a 50 percent tax penalty. Important: original Roth IRA owners are not subject to required minimum distributions.

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These retirement milestones mark the rules of retirement as they currently stand. If the past is any indication of the future, these rules are subject to change.

If/when they do, current retirement planning strategies could become less effective. As a result, being able to process new information and adapt your plans accordingly will be an important skill to have in retirement.

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Feel free to email us at info@westernreservecm.com with any questions you have. If you would like to schedule time with us to discuss your specific situation click here.

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How to Choose a Retirement Investment Strategy

As you enter retirement, you may be in a position where you are investing outside of your employer-sponsored retirement plan for the first time. This can often leave people feeling confused and overwhelmed.

Something that may be helpful is, to begin with understanding how to approach your retirement investment strategy. Financial author and academic Charles  D. Ellis wrote in The Investor’s Anthology: Original Ideas from the Industry’s Greatest Minds, there are three ways to succeed as an investor.

The first is intellectually difficult, the second is physically difficult and the third is emotionally difficult.

The Intellectually Difficult Approach to Investing

The intellectually difficult way is reserved for those with superior brainpower, and a deep understanding of the markets they are investing in. Think of people like Warren Buffet, Ray Dalio, or George Simons.

The Physically Difficult Approach to Investing

The physically difficult approach requires you to outwork your competition. This is the approach many people on Wall Street take. They are known for working extremely long hours trying to get an advantage over one another.

The Emotionally Difficult Approach to Investing

The emotionally difficult approach requires you to withstand the uncomfortable emotions you experience when investing. This discomfort can include the pain of missing out on an investment or the dread brought on by a bear market. Everyone’s tolerance for emotional difficulty is different and can change over time.

Managing an Emotionally Difficult Retirement Investment Strategy

Assuming you are not of superior intellect, nor do you want to spend your retirement working long hours on investing decisions, you are left with the emotionally difficult route.

In order to increase your likelihood of success, you need to improve your ability to withstand emotionally difficult times in the market. This can be done by creating a long-term investment strategy that is tied to your personal goals.

For example, a primary goal for those in retirement is to fund their expenses not covered by other retirement income. Depending on the amount of income you need, your portfolio will require a certain rate of return.

Typically, the greater rate of return you need to generate, the more risk, you must take. If you are not comfortable with a given level of potential risk you may need to adjust your goals downward.

After creating your long-term investment strategy, you must then execute it. When implementing your strategy, you will need to follow an investing process where you monitor, review, and adjust your portfolio based on your changing needs.

The Role a Financial Advisor Can Play

If you struggle with this, you can seek the support of a fiduciary financial advisor. An advisor can help you develop, optimize and implement an investment strategy suited to your needs in retirement.

They can also show you have this strategy integrates with an overarching retirement plan. Lastly, they can provide an additional layer of support when making investment decisions during uncertain market conditions when emotions are high. 

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A successful retirement investment strategy does not require great genius nor tremendous effort, but it does require you to stick with that strategy in good times and bad.

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Feel free to email us at info@westernreservecm.com with any questions you have. If you would like to schedule time with us to discuss your specific situation click here.

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